There is nothing like optimum capital structure for a firm. The Optimal Capital structure is that Capital Structure at which the weighted Average cost of capital (Ko) is Minimum. It is that combination of Equity and Debt at which the total cost of capital is mini-mum.

Trade-off theory argues that there's an optimal amount of debt of each firm. At this level of debt, firms can take the most advantage of debts. Debts can be tax shield so that they can save money for firms to reinvest in other projects so as to earn more profits. However, debts can be quite dangerous because highly leveraged firms may face bankruptcy and financial distress costs (no matter they're direct or indirect) may increase the cost of debt of the company. Therefore, there must be a level of debt that make the benefits of debt and potential danger of debt offset each other. In another word, the marginal revenue of debt equals the marginal cost of debt. But remember, the real cases are not as easy as we put here.

When a firm procures funds from investors or owners, there will be an explicit or implicit promise to pay return to them. The return is paid in terms of interest which is compulsory paid to all investors and owners, but the return paid to owners in the form of dividends is optional. The dividend decision by any firm, like the investment and financing decisions is also taken for maximization of market price of the share. The term dividend refers to that the portion of profit (after tax) which is distributed among own-ers/shareholders of the firm and the profit which is not distributed is called as retained earnings Dividend Payout Ratio is determined by the dividend policy adopted by the company, and it is im-plemented to decide about the percentage of profits to be distributed by the firm to its own-ers/shareholders. Dividend is always depends on the total profit that a firm acquired after taxes. There are a few factors that affect the Dividend policy of a company. They...

...Solutions to Practice Problems
by Kyung Hwan Shim University of New South Wales Australian School of Business School of Banking & Finance for FINS 3625 S1 2010 May 23, 2010
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These notes are preliminary and under development. They are made available for FINS 3625 S1 2010 students only and may not be distributed or used without the author’s written consent.
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1
Solution for Question 1
Summary Table of Cash Flows t=0 I II CF from Machinery ignoring depreciation Working Capital Level in Working Capital CFs from Working Capital III Revenues Variable Costs Fixed Costs Pre Tax Proﬁt Taxes at 34% After Tax Operating CF’s ignoring Deprec. -245,000 160,000 160,000 -160,000 0 0 0 0 0 0 t=1 0 180,000 20,000 -20,000 800,000 450,000 100,000 250,000 85,000 165,000 t=2 0 212,000 32,000 -32,000 900,000 506,250 100,000 293,750 99,875 193,875 t=3 55,000 0 -212,000 +212,000 1,060,000 596,250 100,000 363,750 123,675 240,075
PV of CFs from Tax Shield Gains =
C × d × TC 1 S × d × TC − × n r+d (1 + r) r+d 1 55, 000 × 25% × 34% 245, 000 × .25 × .24 − × = 9% + 25% (1 + .09)3 9% + 25%
= 50, 632.50 20, 000 32, 000 212, 000 − + = −41, 579.50 1.09 1.092 1.093 165, 000 193, 875 240, 075 + + = 499, 939 PV of CFs from Oper. Excl. Dep. = 1.09 1.092 1.093 55, 000 PV of CFs from Invest. & Salvage = −245, 000 + = −202, 530 1.093 1 PV of CFs from Terminal Loss = TC (C(1 − d)n − S) × (1 + r)n 1 = .34(245, 000(1 − .25)3 − 55, 000) × = 12, 696.4 (1 + .09)3 PV of CFs...

...notes
By Zhipeng Yan
CorporateFinance
Stephen A. Ross, Randolph W. Westerfield, Jeffrey Jaffe
Chapter 1 Introduction to CorporateFinance ..................................................................... 2 Chapter 2 Accounting Statements and Cash Flow.............................................................. 3 Chapter 3 Financial Markets and NPV: First Principles ofFinance................................... 6 Chapter 4 Net Present Value............................................................................................... 6 Chapter 5 How to Value Bonds and Stocks........................................................................ 7 Chapter 6 Some Alternative Investment Rules................................................................... 8 Chapter 7 NPV and Capital Budgeting............................................................................... 9 Chapter 8 Strategy and Analysis in Using NPV ............................................................... 10 Chapter 9 Capital Market Theory ..................................................................................... 10 Chapter 10 Return and Risk: CAPM ................................................................................ 10 Chapter 11 An Alternative View of Risk and Return: APT ............................................. 11 Chapter 12 Risk, cost of Capital, and Capital Budget...

...ROLE AND PURPOSE This subject aims to introduce to students a range of basic concepts and ideas in modern finance. After completing this subject, participants should know the principles involved in making investment and financing decisions, understand functions of financial markets and financial managers, and possess basic knowledge of option pricing and financial planning. This foundation course prepares students for more in‐depth studies at a later stage. LEARNING OUTCOMES Upon completion of the subject, students will be able to: a. Understand the role of financial managers and the functions of the financial market; b. Understand the concept of present value and its applications in investment appraisal; c. Understand the risk‐return relation and the determination of cost of capital; d. Possess broad knowledge of financing decision‐making under uncertainty and conditions of market imperfection; e. Apply basic finance theory to solve practical problems. ASSESSMENT METHODS
Specific assessment methods/tasks Continuous Assessment 1. Written Assignment (15%) and Tutorial Participation (5%) 2. Midterm Test Final Examination Total % weighting 50% 20% 30% 50% 100 % √ √ √ √ √ √ √ √ √ √ √ √ √ Intended subject learning outcomes to be assessed a b c d e
Note that under the Double-D policy, students have to obtain at least a “D” in both continuous assessment and final examination in order to pass the course. 1
WRITTEN ASSIGNMENT As required by the...

...coupon rate could cause a serious depreciation of funds if this method is used
because; the coupon rate uses the face value of the bond, in order to compute the
bond(s) value, and does not take into consideration the price at which the issue of
this bond was or the redemption value of the bond. The Yield to maturity (YTM)
method is better to use because the Yield to maturity (YTM) method incorporates
all fluctuations and the issuing expenses, if any. Thus, the Yield to maturity
(YTM) method is a better method to use, and not the coupon rate as the required
return for debt.
2. Compute the cost of common equity using the CAPM model. For beta, use the average
beta of three selected competitors. You may obtain the betas from Yahoo Finance.
Assume the risk free rate to be 3% and the market risk premium to be 4%.
Risk free Rate 3%
Market risk premium, MRP 4%
Competitors Beta As on October 6, 2010
Dendreon Corp .65 http://finance.yahoo.com/q/ks?s=RTN+Key+Statistics
Douglas Emmet 1.40 http://finance.yahoo.com/q/ks?s=BA+Key+Statistics
Raytheon Company
Common Stock
1.07 http://finance.yahoo.com/q/ks?s=LMT+Key+Statistics
Average Beta 1.04
a. What is the cost of common equity? (5 pts)
The cost of common equity is the annual rate of return that a company, business,
investor, and so on expect to earn when they are investing in shares of a
company.
The cost of common equity is the risk free rate plus (MRP * Beta) = 7.16%
.65 + 1.40 + 1.07= 3.12...

...costs are 10 percent. The cost of preferred stock is 9 percent and the cost of debt is 7 percent. (Assume debt and preferred stock have no flotation costs.) What is the weighted average cost of capital at the firm’s optimal capital budget?
6. Lamonica Motors just reported earnings per share of $2.00. The stock has a price earnings ratio of 40, so the stock’s current price is $80 per share. Analysts expect that one year from now the company will have an EPS of $2.40, and it will pay its first dividend of $1.00 per share. The stock has a required return of 10 percent. What price earnings ratio must the stock have one year from now so that investors realize their expected return?
7. Heavy Metal Corp. is a steel manufacturer that finances its operations with 40 percent debt, 10 percent preferred stock, and 50 percent equity. The interest rate on the company’s debt is 11 percent. The preferred stock pays an annual dividend of $2 and sells for $20 a share. The company’s common stock trades at $30 a share, and its current dividend (D0) of $2 a share is expected to grow at a constant rate of 8 percent per year. The flotation cost of external equity is 15 percent of the dollar amount issued, while the flotation cost on preferred stock is 10 percent. The company estimates that its WACC is 12.30 percent. Assume that the firm will not have enough retained earnings to fund the equity portion of its capital budget. What is the company’s tax rate?
8....

...investors have to compensate for the undersized horizon by adding value elsewhere in the model. The prime candidate for the value dump is the continuing, or terminal, value. The result is often a completely non-economic continuing value. This value misallocation leaves both parts of the model—the forecast period and continuing value estimate—next to useless.
Some investors swear off the DCF model because of its myriad assumptions. Yet they readily embrace an approach that packs all of those same assumptions, without any transparency, into a single number: the multiple.
Many companies require over ten years of value-creating cash flows to justify their stock prices. Ideally, the explicit forecast period should capture at least one-third of corporate value with clear assumptions about projected financial performance.
While the range of possible outcomes certainly widens with time, we have better analytical tools to deal with an ambiguous future than to place an uncertain multiple on a more certain near-term earnings per share figure. We address the uncertainty issue below.
In reference to the hostile bid of €694 million, what the free cash flow model tells us is that the company is valued around €788 million. The hostile bid from Ryan air is massively undervalued. We must bear in mind that this is only one model and for a complete analysis, we must look at different models and compare.
Section B
Analysts like to use the free cash flow valuation model...

...Fin 3322
Cost of Capital Homework
1. Suppose Garageband.com has a 28% cost of equity capital and a 10% cost of debt capital. The firm’s debt-to-equity ratio is 1.5. Garageband is interested in investing in a telecomm project that will cost $1,000,000 and will provide $600,000 annually for the next 4 years. Given the project is an extension of their current operations, what is the net present value of the this project if the corporate tax rate is 35.
D/E = 1.5, D/V = 1.5/2.5, E/V = 1/2.5, re = 28%, rd = 10%
WACC = (1.5/2.5)*0.10*(1-0.35) + (1/2.5) *0.28 = 15.1%
FV = 0, PMT = 600,000, n =4, r = 15.1% → PV = 1,709,527.73
NPV = 1,709,527.73-1,000,000.00 = 709,527.73
Take the project
2. Suppose the market value of a firm’s equity is worth $100m and the market value of its debt is worth $50m. Also, assume equity beta and debt beta to be 1.2 and 0.3 respectively. Return on debt is 6%. If the market risk premium is 10% and the risk free rate is 3%, calculate:
a) Expected return on equity
0.03 + 1.2(0.10) = 15%
b) WACC using the return on equity from above and the return on debt.
(100/150)*0.15 + (50/150)*0.06 = 12%
c) Asset beta using the equity beta and debt beta.
(100/150)*1.2 + (50/150)*0.3 = 0.9
Suppose the firm discussed above decides to alter its capital structure by repurchasing $20m in equity. It repurchases the $20m in equity by raising $20m in debt. Assume that the debt beta increases to 0.5
d) What is the...

...constant growth dividend valuation model for ordinary shares, and explain the terms in the model. (3 marks)
l) What are the assumptions behind g = rb? (3 marks)
m) Which group of investors prefer capital gains to dividends and why? (3 marks)
n) If a clientele effect exists, what does it imply for dividend policy? (3 marks)
Total Mark (40 marks)
Section B: Answer All Parts of the Question
Q2 (a)
You have just secured your first job as a financial analyst after successfully completing your postgraduate study. Your first assignment involves demonstrating a thorough grasp of Mean-Variance Analysis and Portfolio Theory, which coincidentally was your most favourite topic in Principles of Modern Finance module. Before your arrival, a more experienced analyst had been working on two projects for a client, and has already estimated the risk and return characteristics of two projects as well as the correlation coefficient between the projects. These are given in the table below:
Project 1 Project 2
Expected return 12% 20%
Risk (std dev) 3% 7%
Correlation between the
Project = + 0.1
The client plans to invest 80% of its available funds in Project 1 and 20% in Project 2.
Following your employment, the senior analyst has been moved to a new and more challenging task and you have been asked to complete the assignment as indicated below.
Required:
(i) To...