Tag Archives: Financialliteracy

Solution to Management Science Series #174: Capital Structure and WACC🧮

You have calculated the unlevered beta of Adobe as 0.79 (actually, this is the answer of the question posted on the 4th of January, 2025. If your estimate were different from that value in higher orders of magnitude, you should check your model and assumptions).

Adobe’s cost of debt is estimated to be 3% as of August 2024.

For the risk-free rate, use the current yield on 10-year US Treasuries (9th of August, 2024).

Equity risk premium will be 6.5%. Corporate tax rate for Adobe is 21%.

You want to investigate how the WACC of Adobe will change in changing capital structures.

Assume that the cost of debt for Adobe does not increase with the amount of debt in the capital structure (seemingly not realistic but there are such cases; do you know why?).

Investigate how the cost of equity and WACC will change with changing debt-to-assets ratios, i.e. start from 0% and incrementally increase it by 15% and stop when the ratio hits 90%.

Plot the cost of equity, cost of debt, and WACC at changing debt to asset ratios!

Solution to Management Science Series #173: How to estimate project betas 🧮Adobe Example

How to estimate project betas 🧮

Adobe plans to invest in a project, risk of which is similar to company’s own risk.

Nonetheless, Adobe plans to finance this project with only equity (100% equity-financed).

Estimate the beta of this project!

On Capital Asset Pricing Model (CAPM) and its real-world validity: Investigating Amazon stock

Does CAPM really do its job of simplifying the calculation of cost of equity and returns on individual stocks? How is its predictive power in estimating stock returns? Can it cause the returns on very disparate stocks to converge? What can one do to assess the risk of and returns on stocks better?
In this article, I investigate Amazon stock and compare the expected returns on Amazon stock calculated through the use of different approaches while also discussing the perils of CAPM.

Solution to Management Science Series #172: Real world example: Cost of Equity of Netflix 🧠

Calculate the cost of equity for Netflix.

Calculate two betas; one for the last 10 years and the other for the last 5 years.

Use the equity risk premium you calculated in the previous post through the historical approach.

Solution to Management Science Series #171: Estimating Equity Risk Premiums

Calculate the implied equity risk premium!

Assume that S&P 500 is the market portfolio.

Base your calculations on the data for 2022 year-end.

Assume that consensus analysts’ 5-year growth rate to forecast cash flows for the next five years is 5% a year.

For the terminal growth rate, use the yield on the 10-year US Treasury.

Also calculate the equity risk premium by using the historical approach and observing the last 50 years, using 2022 as the end year!

Compare the results you get from both methods!

Solution to Management Science Series #170: Which risk-free rate?  🧠

Which risk-free rate?
1. You need to value a Turkish company whose revenues and expenses are in Turkish Liras. What should the risk-free rate be in this valuation?
2. As an investor, you want to consider the default risk of the government in your valuation for this company. What should the risk-free rate be in that valuation?

Detecting Fraudulent Practices in Financial Statements: Close Look at Inventory Fraud and Solution to the question asked

There are many different types of frauds in financial accounting.

Many times, even the most trained eyes cannot detect frauds on financial statements.

The most basic one is inventory fraud.

Solving the following example will lead you to evidence.⬇️

“Amazing” company overstated its ending inventory by $20MM for the year.

What are the effects of this deliberate act on following accounts given a corporate income tax of 25%?

-Current and next year’s net income?
-Current and next year’s retained earnings?
-Next year’s inventory?
-Current and next year’s cash flows from operations?

Solution to Management Science Series #169: How to account for the bonds: NVIDIA 🧮

Refer to the NVidia’s 10-K for the fiscal year ended January 31, 2021. Find the information related to the bonds issued by the company.
Answer the following questions related to the bonds defined as “2.85% Notes Due 2030”

a. Were these notes initially recorded at par, at a discount, or at a premium?

b. What was the effective market rate at the time the notes were issued? Assume that it was not given. So, you are expected to calculate it! (Since current NBV of the bond is equal to the bond principal (probably because of the rounding), first calculate the NBV that should have been reported without the rounding, by using the effective interest rate given. Then, calculate the effective market rate from there!)

c. What will be the exact carrying value (net book value) of the notes at the end of 2025 (or January 31st, 2026)?

d. Assume further that as of December 31, 2025, the prevailing market rate for interest obligations similar to NVidia’s Notes due 2030 will be 7%. What would be the carrying value (net book value) of the notes at the end of 2025?

e. Now assume further that NVidia would redeem these notes from their holder at market value at the end of 2025. Which of the company’s financial statements would be affected, in what direction, and by how much? (Ignore taxes).

f. Assume that as of December 31, 2025, the prevailing market rate for interest obligations similar to NVidia’s Notes due 2030 will be 2%. What would be the carrying value (net book value) of the Notes at the end of 2025? If the company were to decide to retire these bonds, which accounts would be affected?

Solution to Management Science Series #167: Estimating the risk of Apple’s automotive venture

Estimating the risk of Apple’s automotive venture (will it ever happen?) 🧮

Apple is considering entering automotive industry. The analysts at Apple identified three pure plays: namely, Ford, General Motors, and Stellantis.

Determine the risk of this new project for Apple! Applicable tax rate is 35%! Use appropriate current yields on risk-free assets! Equity risk premium is estimated to be 7.4%. For all pure plays, proxy market is S&P 500.

Assume that Apple’s new project will be 100% equity-financed. Assess whether the value for the risk of this new project would make sense practically!