...Financial Management Weighted Average Cost of Capital 1 Weighted Average Cost of Capital (WACC) • This lecture answers the following questions: - What is the “opportunity” cost of funds for a firm, and thus the firm’s discount rate used in NPV calculations? - What is a firm’s Asset Beta & how do we lever Asset Betas and unlever Equity Betas? - Link to previous lectures - No longer use a “given” discount rate. We will calculate the correct discount rate for our NPV calculations. WACC - 1 2 1.0 The Cost of Capital: Some Preliminaries • A. Required (rate of) Return versus Cost of Capital • Cost of capital - required return - appropriate discount rate all denote the same opportunity cost of using capital in one way as opposed to an alternative investment in the financial market having the same systematic risk. – required return: is from an investor's point of view – cost of capital: is the same return from the firm's point of view – appropriate discount rate: is the same return yet again to be used in a present value calculation WACC - 2 3 B. Required (rate of) Return • COMBINING BOTH INVESTORS’ AND FIRMS’ PERSPECTIVES: • A FIRMS COST OF CAPITAL OR DISCOUNT RATE IS GIVEN BY INVESTORS REQUIRED RATE OF RETURN. • RETURN TO INVESTMENT DECISION!! • NPV of a project is dependent on: • (1) EXPECTED CASH FLOWS • (2) RISK WACC - 3 4 3 Determinants of Required (Rate of) Return • What are investors’ concerned with? (and thus firms should also be concerned...
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...WEIGHTED AVERAGE COST OF CAPITAL (WAAC) 4/28/2015 Table of Contents TASK REQUIREMENT 25% 3 WEIGHTED AVERAGE COST OF CAPITAL (WACC) 3 WACC Formula: E /V * Re + D/V *Rd * (1-Tc) 3 DEMONSTRATION OF APPLICATION KNOWLEDGE 55% 5 Describe capital structure 5 Indicate how these might be useful to determine the feasibility of the capital project 5 Recommend which is more appropriate to apply to project evaluation. 5 Define marginal cost of capital 5 ACADEMIC WRITING 20% 7 References 7 Footnotes 8 Tables 9 Figures 10 TASK REQUIREMENT 25% WEIGHTED AVERAGE COST OF CAPITAL (WACC) WACC Formula: E /V * Re + D/V *Rd * (1-Tc) The acronyms in the formula are• Re = Cost of equity or CAPM • Rd = Cost of debt • E = Market value of the firm's equity (market cap) • D = Market value of the firm's debt • E/V = Percentage of financing that is equity • D/V = Percentage of financing that is debt • Tc = Corporate tax rate The following assumptions are received from Mary Frances (CFO) of Apex to be used in the WACC calculation: * Weights of 40% debt and 60% common equity (no preferred equity) * A 35% tax rate * Cost of debt is 8% * Beta of the company is 1.5 * Risk-free rate is 2% * Return on the market is 11% Using Ms. Frances data below you will see the calculations in determining the WACC. Below in table 1 the calculations for inputs and outputs and have been tabulated based on below formula for the WACC. Cost of equity is 18.50% and...
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...the company's tax rate is 40%. What is the component cost of debt for use in the WACC calculation? A. 5.40% B. 5.73% C. 5.98% D. 6.09% E. 6.24% 2) Assume that Mary Brown Inc. hired you as a consultant to help it estimate the cost of capital. You have been provided with the following data: D0 $1.20; P0 $40.00; and g 7% (constant). Based on the DCF approach, what is Brown's cost of equity from retained earnings? A. 10.06% B. 10.21% C. 10.37% D. 10.54% E. 10.68% 3) Crum International's target capital structure calls for 80% debt and 20% equity. The company expects to have $3 million of net income this year, and 60% of the net income will be paid out in dividends. How large can the firm's capital budget be this year before it will have to issue new common stock? A. $5.5 million B. $6.0 million C. $6.3 million D. $6.8 million E. $7.1 million 4) Assume that you are on the financial staff of Christopher Inc., and you have collected the following data: (1) The yield on the company's outstanding bonds is 7.0%, and its tax rate is 40%. (2) The expected year-end dividend is $0.80 a share, the dividend is expected to grow at a constant rate of 6% a year, the price of Christopher's stock is $25 per share, and the flotation cost for selling new shares is 10%. (3) The target capital structure is 40% debt and 60% equity. What is Christopher's WACC assuming that it must issue new stock to finance its capital budget? A. 7.11% B. 7.26% C. 7.41% D. 7.67% E. 7...
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...Midland Energy Resources Case Analysis Midland Energy Capital Planning Model • Fund significant overseas growth • As domestic natural resources dwindle, overseas investments are the main drivers of growth for Midland. These investments are analyzed and evaluated is US dollars (foreign cash flows are converted to US dollars) and have a US dollar discount rate applied to them. In 2006, 77.7% of Midland’s total earnings from equity affiliates came from non-US investments. • Invest in value creating projects across all divisions • Midland generally used traditional discounted cash flow methods to evaluate potential projects and investments. Some overseas projects were analyzed as streams of future equity cash flows, and were discounted based on cost of equity as a result. Once funded, a project/investment’s performance was measure in two ways. The first being actual performance vs forecasted plan over 1, 3, and 5 year periods, and the second being Economic Value Added (EVA). EVA was calculated as: EVA = EBIT(1-t) – WACC(period capital expenditure) Midland Energy Capital Planning Model • Optimize capital structure • Midland primarily optimized its capital structure by taking advantage of the borrowing capacity inherent in its energy reserves and long term assets, such as refining facilities. Midland maintained an optimal debt level which was based on energy prices and its own stock prices. This practice allowed them to shield additional profits from...
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...have the same dividend yield. * b. If the stock market were efficient, these two stocks should have the same price. c. If the stock market were efficient, these two stocks should have the same expected return. d. Statements a and c are correct. The total return is made up of a dividend yield and capital gains yield. For Stock A, the total required return is 10 percent and its capital gains yield (g) is 7 percent. Therefore, A’s dividend yield must be 3 percent. For Stock B, the required return is 12 percent and its capital gains yield (g) is 9 percent. Therefore, B’s dividend yield must also be 3 percent. Therefore, statement a is true. Statement b is false. Market efficiency just means that all of the known information is already reflected in the price, and you can’t earn above the required return. This would depend on betas, dividends, and the number of shares outstanding. We don’t have any of that information. Statement c is false. The expected returns of the two stocks would be the same only if they had the same betas. 2. If D1 = $2.00, g (which is constant) = 6%, and P0 = $40, what is the stock’s expected capital gains yield for the coming year? a. 5.2% b. 5.4% c. 5.6% d. 6.0% * [pic] 3. The Lashgari Company is expected to pay a dividend of $1 per share at the end of the year, and that dividend is...
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...Midland Energy Resources, Inc.: Cost of Capital Analysis TABLE OF CONTENTS I. EXECUTIVE SUMMARY ........................................................................................ 2 II. COMPONENT ESTIMATIONS ............................................................................... 2 1. Effective Tax Rate - t ............................................................................................. 2 2. Capital Structure – D/E ......................................................................................... 3 3. Cost of Debt - r" .................................................................................................... 3 Exploration & Production (E&P) ................................................................................ 3 Refining and Marketing (R&M).................................................................................. 4 Petrochemicals ......................................................................................................... 4 4. Cost of Equity -r# ................................................................................................... 4 1) r$ ........................................................................................................................ 4 2) βlevered ............................................................................................................. 4 Exploration & Production (E&P) .................................................................
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...results that indicate how well they made investment decisions (capital budgeting). A company can make poor investment decisions and still remain profitable, but only for a time. A company cannot continually make poor investment decisions and remain profitable forever. When looking at the Coke vs Pepsi case study, we find that Doug Ivester, then CEO of Coke, made a bad investment decision when he chose to increase the rate charged for syrup to franchisers. As a result, bottlers raised prices to improve profitability, and in turn there was a decrease in overall sales volume. During the time Ivester was CEO, the net income for Coke fell 41% and he ended up without a job. Had this been a trend that continued, Coke would have been out of business, but they rebounded and remain profitable. This example shows that a company can make a bad decision and continue to be profitable in the long run. But, repeat bad investment decisions and a company will go broke. Question #5 How does WACC change over time? What do you think might drive the changes? WACC is the opportunity cost of investing in a company, or the expected return of shareholders and debt holders. WACC consists of all capital sources and includes common stock, preferred stock, short-term debt and long-term debt in the calculation. WACC is the average costs of capital financing, and tells us how much a company has to pay for each dollar of financing. WACC for any company will...
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...Chapter 11 The Cost of Capital Sources of Capital Component Costs WACC Adjusting for Flotation Costs Adjusting for Risk 11-1 What sources of long-term capital do firms use? Long-Term Capital Long-Term Debt Preferred Stock Common Stock Retained Earnings New Common Stock 11-2 Calculating the Weighted Average Cost of Capital WACC = wdrd(1 – T) + wprp + wcrs The w’s refer to the firm’s capital structure weights. The r’s refer to the cost of each component. 11-3 Should our analysis focus on before-tax or after-tax capital costs? Stockholders focus on A-T CFs. Therefore, we should focus on A-T capital costs, i.e. use A-T costs of capital in WACC. Only rd needs adjustment, because interest is tax deductible. 11-4 Should our analysis focus on historical (embedded) costs or new (marginal) costs? The cost of capital is used primarily to make decisions that involve raising new capital. So, focus on today’s marginal costs (for WACC). 11-5 How are the weights determined? WACC = wdrd(1 – T) + wprp + wcrs Use accounting numbers or market value (book vs. market weights)? Use actual numbers or target capital structure? 11-6 Component Cost of Debt WACC = wdrd(1 – T) + wprp + wcrs rd is the marginal cost of debt capital. The yield to maturity on outstanding L-T debt is often used as a measure of rd. Why tax-adjust; i.e., why rd(1 – T)? 11-7 A 15-year, 12% semiannual coupon bond sells for $1,153.72. What is the cost of debt (rd)? Remember...
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...“Calculate and make a recommendation on how Telus should employ their cost of capital." Introduction: In introducing this case the basic problem do be solved deals with determining the cost of capital within the organization of Telus. Barb Williams and Rick Thomas both managers from service firms, were attending a business seminar when given an assignment to calculate the cost of capital for Telus. They were given basic data including balance sheets, income statement, data on Telus common stock, market index, and average annual returns in North America capital markets. This information was given to them in order to calculate the cost of capital within the company and to make a recommendation on how to employ their cost of Capital. In order to determine the actual cost of capital, various steps need to be taken in finding out cost of debt, equity, preferred shares in order to determine the overall weighted average cost of capital (WACC) within the company. What is WACC? Weighted average cost of Capital is defined as a calculation of a firm’s cost of capital in which each category of capital is properly weighted. All capital resources are used in determining this cost which includes common stock, preferred stock, bonds and any other long term debt. Calculating overall WACC. Use of short and Long term debt When calculating the cost of debt for this case, it is necessary to take into account both the long and short term components of Telus’ financing via debt...
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...Answer the following questions concerning WACC: 1. What is the WACC of the company? The WACC for Verizon Communications Inc. is 4.74% 2. What does WACC represent to the firm? The WACC is the rate that a company is expected to pay on average to all its security holders to finance its assets. It is the rate of return required by investors. Investors use WACC as a tool to value a project. If the project is below WACC, it will not generate enough return for the Investor. 3. How does Beta influence the WACC? Beta represents the measure of risk of the company. When using the capital asset pricing model, the beta coefficient is an index of risk. When the risk increases, the investor will expect a higher rate of return. So when the beta increases, it will cause the WACC to increase as well. 4. How does the Risk Free Rate influence the WACC? Another component of the CAPM is the risk free rate, generally taken to be a long-term U.S Treasury bond rate. It is like the opportunity cost for the investors, instead of putting their money in the new investment, they can earn a risk free rate or interest by putting the money into a long-term U.S treasury bond. Therefore, the increase in risk free rate leads to increase in WACC. 5. How does the WACC for a firm and the IRR of a project within the company correlate to each other? A project’s IRR is the discount rate that forces the PV of the expected future cash flows to equal the initial cash flow. It is an estimate of...
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...billion and $42.2 billion respectively. Among these three divisions, E&P was Midland’s most profitable business, R&M was Midland’s largest business, and Petrochemical was Midland’s smallest yet still substantial business. In 2007, Midland’s financial strategy will mainly focuses on four aspects: 1) Fund Overseas Growth; 2) Value-creating Investments; 3) Optimize Capital Structure; 4) Repurchase undervalued stocks. Fund Overseas Growth: Due to the exploited domestic resources in the domestic market, overseas investment will be the main sources for economic growth in Midland as a form of specialized financial and contractual arrangements similar to project financing, all of which are valued in dollars. Value-creating Investments: Discounted Cash Flow (DCF) methods, involving debt-free cash flows and a hurdle rate equal to or derived from the WACC for the project of division, are typically used to evaluate most prospective investment, yet for overseas projects are evaluated as streams of future equity cash flows and discounted as a rate based on the cost of equity. Optimize Capital Structure: Midland optimized its capital structure by carefully exploring the borrowing capacity inherent in its energy reserves and in long-lived productive assets such as refining facilities, and based on the annual operating cash flow and collateral value of its identifiable assets, each division has its own target debt ratio. Repurchase undervalued stocks: Possibilities to repurchase its own shares...
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...arriott Corporation: The Cost of Capital (Abridged) Executive Summary: The case "Marriott Corporation: The Cost of Capital (Abridged)" focuses on an ideal opportunity to review the capital asset pricing model and the weighted average cost of capital through calculation of the cost of capital for Marriott as a whole. Dan Cohrs is faced with making recommendations for the hurdle rates at Marriott Corporation and its three divisions utilizing CAPM and WACC. This case illustrates how to calculate beta based on comparable companies and to lever betas to adjust for capital structure; the appropriate risk-less rate and market risk premium; the choice of time period to estimate expected returns and the difference between the geometric and the arithmetic average as a measure of expected returns. SYNOPSIS Marriott Corporation began in 1927, and over the next 60 years, the company grew into one of the leading lodging and food service companies in the US. In 1987, the Marriott's annual report stated, "We intend to remain a premier growth company. Our goal is to be the preferred employer and provider, and the most profitable company". Marriott's profits were $223 million on sales of $6.5 billion. In April 1988, vice president of project finance at the Marriott Corporation, Dan Cohrs, must prepare annual recommendations for the hurdle rates at each of the firm's three divisions, including restaurant, lodging, and contract services, as well as...
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...Midland Energy Resources, Inc.: Cost of Capital Executive Summary Midland Energy Resources, Inc. is a global energy company comprised of three different operations – oil and gas exploration (E&P), refining and marketing (R&M), and petrochemicals. E&P is Midland’s most profitable business, and midland anticipated continued heavy investment in acquisitions of promising properties, in development of its proved undeveloped reserves, and in expanding production. Midland wanted to boost investment in sophisticated extraction methods, and capital spending in E&P was expected to exceed $8 billion in 2007 and 2008. R&M is Midland’s largest division, measured my revenue. The relatively small margin was consistent with a long-term trend in the industry, and Midland projected capital spending in R&M would remain stable. Petrochemicals is Midland’s smallest but most promising division. Capital spending in petrochemicals was expected to grow in the near term. Much of the new investment would be undertaken my joint ventures outside US. The primary goals of Midland’s financial strategy are to fund substantial overseas growth, invest in value-creating projects, optimize capital structure, and repurchase undervalued shares. To achieve these goals, Midland must calculate an appropriate cost of capital that will allow reasonable valuations of their strategies. Janet Mortensen, the senior vice president of project finance for Midland Energy Resources, has been asked to...
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...status as a premier growth company, weighted average cost of capital (WACC), divisional hurdle rates, and justification of numbers used in calculations. Marriott’s strategic plan to maintain its status as a premier growth company can be broken into four distinct areas: managing (as opposed to owning) hotel assets, choosing investments that increase shareholder value, optimizing the use of debt within the capital structure, and repurchasing undervalued shares. The choice to manage hotel assets has the benefit of freeing up capital to invest in other opportunities. This allows for more growth throughout the company. Investing in projects that increase shareholder value through the use of a discounted cash flow technique also enhances growth opportunities. Optimizing the debt portion of their capital structure allows them to focus on the ability to service their debt, instead of targeting a debt to equity ratio. This ensures that their capital is efficiently utilized. The final financial strategy to discuss here is Marriott’s repurchasing of undervalued shares. This allows for more retained earnings, which again speaks to their efforts to efficiently utilize capital. All four of these strategic decisions ensure that capital is efficiently utilized towards growth, which is clearly in line with the company’s goal of remaining a premier growth company. Marriott uses the weighted average cost of capital (WACC) as part of their project evaluation methodology. This is the rate that is used...
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...Nike, Inc.: COST OF CAPITAL CASE ANALYSIS Importance of Cost of Capital The concept of cost of capital is used in finance decisions. Acceptance or rejection of an investment project depends on the cost that the company has to pay for financing it. Good financial management calls for selection of such projects, which are expected to earn returns, which are higher than the cost of capital. It is therefore, important for the finance manager to calculate the cost of capital, which the company has to pay and compare it with the rate of return, which the project is expected to earn. In capital expenditure decisions, finance managers go on accepting projects arranged in descending order of rate of return. The manager stops at the point where the cost of capital equals to the rate of return offered by the project. That is, the finance manager finds out the break-even point of the project. Accepting any project beyond the break-even point will cause financial loss for the company. The cost of capital is a guideline for determining the optimum capital structure of a company. Weighted Average Cost of Capital The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital. A company's assets are financed by either...
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