Sterling Household Products Essay

For the purpose of calculating the net present value of the project, an appropriate cost of capital has to be calculated at which free cash flows of the project should be discounted. Since the project will be solely financed by selling new shares, cost of equity will be used as the discount rate. Beta for the company can be assumed to be equal to average of the betas of the competitors of the company. This average beta value comes out to be 1.2. Risk free rate is 0.17% while risk premium has been estimated to be 6%. Thus by putting these values in CAPM formula, we can find the cost of equity for the company which is 7.39%.

Cost of Equity = Risk free rate + (Market return – risk free rate) X beta

Please refer to Appendix 2 for other considerations for cost of equity calculations. Most firms use the Capital Asset Pricing Model (CAPM) to determine the cost of equity. The components that make up the CAPM include: the risk free rate, the beta of the security, and the expected market return of the stock. These values are all based on forward-looking data. The model dictates that shareholders require a return equal to the return from a risk-free investment plus an equity risk premium for bearing extra risk. Refer to Appendix 1 for a full breakdown of the CAPM formula.

Cost of Equity is the return that stockholders require for a company. A company’s cost of equity represents the compensation that the market demands in exchange for owning the assets and bearing the risk of ownership. Based on capital markets the cost of equity varies in direct relation to the assumed risk in that specific market. The distinctive of the firm is the sensitivity to market risk (β) which depends on everything from management to its business and capital structure. Therefore past performances and present conditions have a direct effect on the overall value. Applying calculations at a divisional level allows specified markets to be analysis based on present market conditions for that service or product. The formula used to calculate Cost of Equity is:

James Gitanga was not sure about the unusual capital structure of the Company, avoiding the long-term debt. We believe that the long-term capital structure across the industry was pre-determined by the high capital expenditures and steady cash inflows. Thus, issuing long-term debt was more preferable. Besides, by issuing debt they would enjoy the tax shield since interest on long-term debt is tax-deductible.

Using the same market risk premium and risk free rate (5.5% & 4.62% respectively) given in the case, the averaged beta of 1.40, the pretax cost of debt of 7.65%, and the weighted average of debt & equity, the products & systems

3.3 Calculating the costs of equity by the earnings capitalization ratio, and its advantages & disadvantages i. Calculation (based on EXIHIBIT 1&4) According to the earnings capitalization model, we have cost of equity = E1 / P0 = 2.16 / 42.09 = 5.13%

It was determined that the liquidation of $209 million in cash and marketable securities and the addition of $50 million in long-term would result in a capital structure which was reasonable and sustainable. Overall, tax expense would be lower, the value of the firm would increase and the riskiness of the company’s equity would edge just a touch higher.

2. Another method of deriving the cost of equity is by using the capital asset pricing model (CAPM). The underlying assumption of CAPM is that the market is pricing in the risk of the stock in relation to the risk of the market. This firm-specific risk is the cost of equity for the firm. The formula for CAPM is:

A firm's cost of equity represents the compensation that the market demands in exchange for owning the asset and bearing the risk of ownership. It is basically the return that stockholders require for a company. Cost of equity can be determined using the Capital Asset Pricing Model (CAPM).

MCI would be better to keep its capital structure of 55% debt. The cost of equity is high because raising more equity will dilute the value for existing shareholders. Due to the fact that MCI has a high leverage, it is not feasible to issue debt. Additionally, MCI has exhausted the line of credit from the banks and used convertible debentures frequently. MCI belongs to a competitive and regulatory industry. The high leverage will limit its potential to grow. In exhibit 8, MCI does not have a bond rating. The convertible bond allowed the company to raise capital and convert to equity later. The interest coverage ratio of AT&T is 3.6X whereas that of MCI is 4.2X. After increasing the market share, the company can obtain a bond rating by decreasing its financial leverage.

Financial performance of firm and its value is greatly affected by the design of its capital structure. This issue is getting immense consideration after the MM,

Part I. Estimating the cost of capital is challenging, because the cost of capital effectively puts a price on the risk of the project. If we know the risk, it would not be risk, it would be certainty. Inherently, then, there is a philosophical challenge with finding a good estimate of the firm's cost of capital. It is assumed, however, that the market view of the firm is a fairly accurate reflection of the company's risks. The main techniques for estimating the cost of capital, therefore, are market based. In general, these market based solutions are only used to determine the cost of equity with the scope of a broader weighted-average cost of capital equation.

However, unlike debt, equity does not need to be paid back if earnings decline. On the other hand, equity represents a claim on the future earnings of the company as a part owner. The cost of equity is complicated in the sense that the rate of return demanded by equity investors is not as clearly defined as it is by lenders. Theoretically, the cost of equity is approximated by the Capital Asset Pricing Model (CAPM) = Risk-free rate + (Company’s Beta x Risk Premium).

From the investors point of view, the cost of capital is the rate of return expected by those who invested funds in the business which includes interest payment and dividend commitments. (Book) It is the cost of company’s debt and equity. Cost of capital is based on the funds used. Many companies use a composition of both debt and equity to finance their business. For such