Assume that you recently graduated and have just reported to work as an investme
ID: 2812761 • Letter: A
Question
Assume that you recently graduated and have just reported to work as an investment advisor at the brokerage firm of Balik and Kiefer Inc. One of the firm’s clients is Michelle DellaTorre, a professional tennis player who has just come to the United States from Chile. DellaTorre is a highly ranked tennis player who would like to start a company to produce and market apparel she designs. She also expects to invest substantial amounts of money through Balik and Kiefer. DellaTorre is very bright, and she would like to understand in general terms what will happen to her money. Your boss has developed the following set of questions you must answer to explain the U.S. financial system to DellaTorre.
f. What are free cash flows?
g. What is the weighted average cost of capital?
h. How do free cash flows and the weighted average cost of capital interact to determine a firm’s value?
j. What do we call the cost that a borrower must pay to use debt capital? What two components make up the cost of using equity capital? What are the four most fundamental factors that affect the cost of money, or the general level of interest rates, in the economy?
k. What are some economic conditions that affect the cost of money?
p. What are the differences between market orders and limit orders?
Explanation / Answer
f. Free cash flow is the cash left after meeting the operating expenses and any capital expenditure(CAPEX).
It is cash available to be paid to equity shareholders as dividends .
g. The WACC represents the opportunity cost that investors face for investing their funds in one particular business instead of others with similar risk.The weighted average cost of capital is the market-based weighted average of the after-tax cost of debt and cost of equity
To determine the weighted average cost of capital, we must calculate its three components: (1) the cost of equity, (2) the after-tax cost of debt, and (3) the company’s target capital structure.
h. The formula for free cash flow is
OFCF = EBIT(1-T) + depreciation - CAPEX - D working capital - D any other assets
EBIT = earnings before interest and taxes
T= tax rate
CAPEX = capital expenditure
This is also referred to as the free cash flow to the firm, and is calculated in such as way to reflect the overall cash-generating capabilities of the firm before deducting debt related interest expenses and non-cash items. Once we have calculated this number, we can calculate the other metrics needed such as the growth rate.
j. The price that a borrower must pay to use debt capital i.s called intertest rate. The two components of cost of equity is dividends and capital gains
The four factors that affect the cost of money are production oppurtunities, time prefrence, expected inflation and risk