...THE CAPITAL ASSET PRICING MODEL This note discusses how some of the most financially sophisticated companies and financial advisers estimate the cost of equity capital. We particularly focus on areas where finance theory is silent or ambiguous, and practitioners are left to their own devices. Conclusions are based on interviews with two groups: (1) well-regarded firms ranked by peer companies as industry leaders and (2) a sample of 11 of the most active financial advisers (investment banks). For context on academic advice, we also cite recommendations from topselling graduate-level textbooks and trade books in corporate finance.1 Findings The Capital Asset Pricing Model (CAPM) is the dominant model for estimating the cost of equity, with over 90% of firms and all the financial advisers employing this model. Moreover firms and advisers seldom mentioned other asset-pricing models. Yet disagreements exist on how to apply the CAPM. The CAPM states that the required return (R) on any asset can be expressed as Equation 1: R = R f + ( Rm - R f ) (1) 1 Survey evidence and much of the discussion is adapted from T. Brotherson, K. Eades, R. Harris, and R. Higgins, “‘Best Practices’ in Estimating the Cost of Capital: An Update,” Journal of Applied Finance 23, no. 1 (2013), which is an update of an earlier article: R. Bruner, K. Eades, R. Harris, and R. Higgins, “‘Best Practices’ in Estimating the Cost of Capital: Survey and Synthesis,” Financial Practice and Education...
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... 1.4 Structure of this guide 3 1.5 Related guides and frameworks 3 1.6 The need for an accurate project budget 4 2. Elements of a project budget 5 2.1 The headline elements of a project budget 5 2.2 Successful financial planning 9 2.3 The need for a whole-of-life approach 10 2.4 ‘Poor project planning’ risks are not project risks! 10 2.5 Delivering to budget 11 3. Foundations for good project budgets 12 3.1 Better business cases and better project budgets 12 3.2 Preparing to develop a project budget 13 3.3 Developing a project budget 15 3.4 Culture, incentives and governance 17 4. Developing base cost estimates 19 4.1 Essential ingredients for an accurate base cost estimate 19 4.2 Clearly defined project scope 19 4.3 Competent, experienced estimators prepared to certify their work 21 4.4 A...
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...Case 12 “Best practices “in Estimating the Cost of Capital The Cost of Capital The purpose of this case is to present evidence on how some of the most financially sophisticated companies and financial advisers estimate capital costs. This evidence is valuable in several respects. First, it identifies the most important ambiguities in the application of cost-of-capital theory, setting the stage for productive debate and research on their resolution. Second, it helps interested companies benchmark their cost-of-capital estimation practices against best-practice peers. Third, the evidence sheds light on the accuracy with which capital costs can be reasonably estimated, enabling executives to use the estimates more wisely in their decision-making. Fourth, it enables teachers to answer the inevitable question, “How do companies really estimate their cost of capital?” Survey Findings The detailed survey results appear in Exhibit 2. The estimation approaches are broadly similar across the three samples in several dimensions. • Discounted Cash Flow (DCF) is the dominant investment-evaluation technique. • WACC is the dominant discount rate used in DCF analyses. • Weights are based on market not book value mixes of debt and equity.8 • The after-tax cost of debt is predominantly based on marginal pretax costs, and marginal or statutory tax rates. • The CAPM is the dominant model for estimating the cost of equity. Some firms mentioned other multi-factor asset-pricing models...
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...include materials submitted to McGraw−Hill for publication by the instructor of this course. The instructor is solely responsible for the editorial content of such materials. 111 MBAP ISBN: 0−390−42334−3 MBA Program Contents Bruner • Case Studies in Finance: Managing for Corporate Value Creation, 4/e II. Financial Analysis and Forecasting 1 1 6 16 16 39 52 52 60 66 66 84 100 100 6. The Financial Detective, 1996 11. ServerVault: ‘‘Reliable, Secure, and Wicked Fast’’ III. Estimating the Cost of Capital 12. ‘‘Best Practices’’ in Estimating the Cost of Capital: Survey and Synthesis 15. Teletech Corporation, 1996 IV. Capital Budgeting and Resource Allocation 19. Diamond Chemicals PLC (A): The Merseyside Project 20. Diamond Chemicals PLC (B): Merseyside and Rotterdam Projects VI. Management of the Corporate Capital Structure 29. Structuring Corporate Financial Policy 31. Polaroid Corporation, 1996 VIII. Valuing the Enterprise: Acquisitions and Buyouts 41. Palamon Capital Partners/TeamSystem S.P.A. iii Bruner: Case Studies in Finance: Managing...
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...The purpose of this paper, prepared by Jessica Chan under the supervision of Robert F. Bruner is about analyzing the companies Coca Cola and Pepsi after Pepsi has announced a merger with Quaker Oats Company with a deal at around $14 billion. With this deal Pepsi would have access to 83.6% of the sport drink market and around 33% of the U.S. noncarbonated-beverage market, followed by Coke with 21%. The paper wants to answer the questions how the latest announcement of Pepsi has an effect on the two companies´ prospects for value creation by showing the company background of both companies, giving a briefly industry overview of the beverage market and competitive events and establishing a financial comparison, especially with ratio and economic profit analysis. In the world Coca Cola and Pepsi have towered as the two leading brands of beverages. In the year 2000, Coca Cola was the largest manufacturer, distributor, marketer of soft-drink concentrates and syrups in the world and its market value reached $110.01 billion. On the other side Pepsi was a $20 billion worth company in 2000, acting in the snack food, soft drink and noncarbonated beverage market. Both companies have reached worldwide expansion of their markets, which include a large product range of beverages, apparel and paraphernalia with their respective logos. Both have grown into longstanding global and social industry leaders. Coca Cola´s annual sales were $20.5 billion which were earned also through a variety of...
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...include materials submitted to McGraw−Hill for publication by the instructor of this course. The instructor is solely responsible for the editorial content of such materials. 111 MBAP ISBN: 0−390−42334−3 MBA Program Contents Bruner • Case Studies in Finance: Managing for Corporate Value Creation, 4/e II. Financial Analysis and Forecasting 1 1 6 16 16 39 52 52 60 66 66 84 100 100 6. The Financial Detective, 1996 11. ServerVault: ‘‘Reliable, Secure, and Wicked Fast’’ III. Estimating the Cost of Capital 12. ‘‘Best Practices’’ in Estimating the Cost of Capital: Survey and Synthesis 15. Teletech Corporation, 1996 IV. Capital Budgeting and Resource Allocation 19. Diamond Chemicals PLC (A): The Merseyside Project 20. Diamond Chemicals PLC (B): Merseyside and Rotterdam Projects VI. Management of the Corporate Capital Structure 29. Structuring Corporate Financial Policy 31. Polaroid Corporation, 1996 VIII. Valuing the Enterprise: Acquisitions and Buyouts 41. Palamon Capital Partners/TeamSystem S.P.A. iii Bruner: Case Studies in Finance: Managing...
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...market for commercial airplanes was depressed because of terrorism risks, war, and SARS, a contagious illness that resulted in global travel warnings. Boeing’s board of directors would need to weigh those considerations before granting final approval to proceed with the project. The task for students is to evaluate the 7E7 project against a financial standard, the investors’ required returns. The case gives internal rates of return (IRR) for the 7E7 project under base-case and alternative forecasts. The students must estimate a weighted-average cost of capital (WACC) for Boeing’s commercial-aircraft business segment in order to evaluate the IRRs. As a result of that analysis, the students identify the key value drivers and distinguish, on a qualitative basis, the key gambles that Boeing is making. The general objective of this case is to exercise students’ skills in estimating a weighted-average cost of capital and cost of equity. The need for students to estimate a segment WACC draws out their abilities to critique different estimates of beta and to manipulate the levered-beta formulas. Boeing competes in both the commercial aircraft and the defense business. Thus, deriving the appropriate benchmark WACC for the 7E7 project requires isolating the commercial aircraft component from Boeing’s overall corporate WACC. In doing so, students...
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...market for commercial airplanes was depressed because of terrorism risks, war, and SARS, a contagious illness that resulted in global travel warnings. Boeing’s board of directors would need to weigh those considerations before granting final approval to proceed with the project. The task for students is to evaluate the 7E7 project against a financial standard, the investors’ required returns. The case gives internal rates of return (IRR) for the 7E7 project under base-case and alternative forecasts. The students must estimate a weighted-average cost of capital (WACC) for Boeing’s commercial-aircraft business segment in order to evaluate the IRRs. As a result of that analysis, the students identify the key value drivers and distinguish, on a qualitative basis, the key gambles that Boeing is making. The general objective of this case is to exercise students’ skills in estimating a weighted-average cost of capital and cost of equity. The need for students to estimate a segment WACC draws out their abilities to critique different estimates of beta and to manipulate the levered-beta formulas. Boeing competes in both the commercial aircraft and the defense business. Thus, deriving the appropriate benchmark WACC for the 7E7 project requires isolating the commercial aircraft component from Boeing’s overall corporate WACC. In doing so,...
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...A Look at Cost of Capital Decisions at Exxon Mobile American Military University Abstract This paper discusses and analyses the cost of capital decisions Exxon Mobile faces after its acquisition of XTO Energy. The advantages and disadvantages of both single company – wide cost of capital and divisional costs of capital are detailed. Finally, the method of estimating the costs of capital and determining how Exxon Mobile could best evaluate the weights to use for various sources of capital is discussed. A Look at Cost of Capital Decisions at Exxon Mobile Due to its recent acquisition of XTO Energy, Exxon Mobile must reevaluate how it determines the proper cost of capital for use in making corporate investments across the company’s many business units. Essentially, Exxon Mobile has two choices, it can either use a single company – wide cost of capital for analyzing capital expenditures or it can evaluate the divisional costs of capital. Both of these two methods offer their own advantages and disadvantages in analyzing capital expenditures, however the divisional weighted average cost of capital is the best choice for Exxon Mobile due to its recent acquisition of XTO energy. The consequences of Exxon Mobile using a company - wide cost of capital are that is could lead to the overinvestment or underinvestment into divisions where the beta varies widely from the company beta (Hung Il, 2008). Companies such as Exxon Mobile have many different divisions that are separated either...
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...GRADUATE PROGRAMME IN MANAGEMENT AY 2015-16 TERM: III TITLE OF THE COURSE: FINANCE II CREDITS: 4 Name of the Faculty Arnab Bhattacharya Gaurav Singh Chauhan Kousik Guhathakurta Radha M. Ladkani Faculty Block/ Room No. J BLOCK C-102 A-106 J BLOCK Email Telephone Number arnabb@iimidr.ac.in gauravs@iimidr.ac.in kousikg@iimidr.ac.in; radhal@iimidr.ac.in; 0731-2439589 0731-2439592 0731-2439518 0731-2439698 COURSE DESCRIPTION The second core course in Finance deals with the core corporate finance functions in an applied setting. The participants are exposed to real world corporate finance decisions to be taken up by managers for creating value. Such an exposure is accomplished through a mix of theory and practice. The pedagogy employed reflects a judicious mix of case discussions, lectures and problem solving approach. COURSE OBJECTIVES The objective is to familiarize participants with the three major decision areas of Corporate Finance, viz. the investments, financing and earnings distribution decisions. Subsequently the participants are to be offered an integrated view of the decision areas by discussing the issues in corporate valuations and risk management. The course aims at sharpening the financial decision making skills of the participants. EXPECTED LEARNING OUTCOMES AND ASSOCIATED MEASURES At the end of the course student is expected to accomplish the following learning outcomes. Alignment of Course Learning Outcomes (CLOs) with...
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...context in which a particular problem is found. Regardless of the particular characteristics of the problem, problem solving follows a general methodology: identification of the problem, describing the context of the problem, analysis of potential alternative solutions, the identification of the best solution, implementation of the best solution , and the creation of controls and contingency plans, if applicable. Text and Other Sources: E-book based on Case Studies in Finance, 6th ed., 2010, McGraw Hill, Toronto, ISBN Prerequisites Management 3412, Fundamentals of Investments Investments, Analysis & Management, 2nd Canadian Ed., 2005, Cleary & Jones, John Wiley & Sons Canada Ltd., Mississauga ISBN 0-470-83542-7 Management 3460, Corporate Finance Fundamentals of Corporate Finance, 6th Canadian Ed., 2007, Ross, Westerfield, Jordan, & Roberts, McGraw-Hill Ryerson, Toronto ISBN 13: 978-0-07-095910-1 A list of topics for which you should have working knowledge follows: 1. Time value of money 2. Market Efficiency 3. Valuation, risk, and return 4. Capital budgeting 5. Cost of capital 6. Pro-forma financial statements 7. Capital structure 8. Dividend policy 9. Portfolio theory 10. Foreign exchange This course is designed not only to deepen your knowledge of concepts already covered in other...
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...Accumulating costs means collecting cost data in an organized manner, such as through a system of accounts. Acquisition planning means the process by which the efforts of all personnel responsible for an acquisition are coordinated and integrated through a comprehensive plan for fulfilling the agency need in a timely manner and at a reasonable cost. It includes developing the overall strategy for managing the acquisition. Actual costs means (except for Subpart 31.6) amounts determined on the basis of costs incurred, as distinguished from forecasted costs. Actual costs include standard costs properly adjusted for applicable variances. Allocate means to assign an item of cost, or a group of items of cost, to one or more cost objectives. This term includes both direct assignment of cost and the reassignment of a share from an indirect cost pool. Allowable means a contract cost is allowable as long as it meets five tests of allowability: reasonableness; allocability; standards promulgated by the CAS Board, if applicable; otherwise, generally accepted accounting principles and practices appropriate to the circumstances; terms of the contract; and any limitations set forth in FAR Part 31. Affected CAS-covered contract or subcontract means a contract or subcontract subject to Cost Accounting Standards (CAS) rules and regulations for which a contractor or subcontractor-- (1) Used one cost accounting practice to estimate costs and a changed cost accounting practice to accumulate...
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...Capital Budgeting One of the most important decisions a financial manager can make involves capital budgeting. Capital budgeting is used to determine which fixed assets should be purchased. The purchasing of fixed assets is a form of a long-term investment. Allocating funds in the capital account is a form of capital budgeting. A financial manager will determine if the purchase of a capital asset or fixed asset is worth more over that assets life then it is for the cost to purchase it. In other words, they make sure that the asset would get the amount it cost plus a profit in return. Financial managers cannot seem to agree on a specific method that works better than the other when it comes to estimating and budgeting. Even in the world of academia, the determination to which method is more accurate or desirable is not certain. Financial managers and academics both have their own theories, however neither seem to agree. To determine if an investment is worth the cash to invest in, one of the ways a financial manager can determine profitability is that they will look at the investments net present value. The amount the investment would cost to payback each year and with how long it would take to pay for the investment may change the financial manager’s mind with if it is a worthy investment. The assets that are invested in are determined by the company’s business. A new building, large equipment, new software or investing into new products or ideas are examples of items...
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...through on the strategy of trying to maximize shareholder wealth. To calculate NPV, however we need to estimate the cash costs and benefits of any decision at hand. In this note we discuss the evaluation of investment proposals. Cash Flows: Basic Concepts The cash flows that we will use in our analysis are incremental after-tax cash flows. The incremental-cash-flow rule is that the cash flows relevant in analyzing an investment opportunity are those after-tax cash flows and only those after-tax cash flows directly attributable to the investment. The words incremental, after-tax and cash are critical. The term cash calls attention to the fact that we are interested in cash flow and not accounting profits. Ultimately, financial transactions must be carried out with cash, not profits, so we look to cash as the source of value. As we will see, we are interested in all cash flows affected by a decision under evaluation, no matter how those cash flows are classified for accounting purposes. The term after-tax emphasizes that we are able to keep the cash only after payment of taxes. The word incremental is important because in deciding whether to do something, or whether to pick alternative A or alternative B, differences in outcomes are of interest. What changes as a result of the decision? If a firm replaces a piece of machinery, will the firm’s insurance costs change? If not, we can ignore the insurance premiums in our schedule of cash flows to analyze the decision about replacing...
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...Limitations | 4 | | (b) Future direction of research | 5 | BEST PRACTICES IN ESTIMATING COST OF CAPITAL 1. THE SCOPE OF THE RESEARCH PAPER: It is a survey research paper presenting the results of the cost of capital survey of advisors, corporations etc showing a close alignment among the groups on the use of common theoretical framework and on many aspects of estimation. Variations are found on large number of joint choices regarding cost of capital. 2. INTRODUCTION TO THE TOPIC: The paper is about presenting evidence that how some of the most financially sophisticated companies and financial advisers estimate capital cost. The evidence to be presents is valuable in several aspects. First is to identify the most important ambiguities in the application of cost of capital theory and the second is helping interested companies benchmarking their cost of capital estimation practices against best practice peers. Third is that the evidence sheds light on the accuracy with which the capital costs can be reasonably estimated. The cost of capital can be computed by the following, i. The weighted average cost of capital. ii. Sample selection. iii. Survey findings. iv. Impacts of various assumptions for using CAPM. 3. RESEARCH METHODOLOGY: This paper presents the results of cost of capital survey of 27 highly regarded corporations, ten leading financial advisors, and seven best-selling text books and trade books. In this...
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