Value Based Management and Capital Budgeting Analysis

The comptroller currently finds the weights for the weighted average cost of capital (WACC) from information from the balance sheet shown in Table 2. Compute the book value weights that the comp­trol­ler currently uses for the company’s capital structure.

1. Determine the Weighted Average Cost of Capital (WACC) based on using retained earnings in the capital structure.

The cost of equity is the theoretical return that equity investors expect or receive from the company for investing their funds in the company. The risk free rate that is the Government Treasury bill rate is 3.1%, the market risk premium is 7% and the beta has been calculated as

a. What risk-free rate and risk premium did you use in calculating the cost of equity for each division? Why did you choose these numbers?

Taking the CAPM equation, we were able to figure out eh cost of equity and in its credit range

Risk free rate + Equity Beta * (Expected return on market - Risk free rate)

Solutions to Valuation Questions 1. Assume you expect a company’s net income to remain stable at $1,100 for all future years, and you expect all earnings to be distributed to stockholders at the end of each year, so that common equity also remains stable for all future years (assumes clean surplus). Also, assume the company’s β = 1.5, the market risk premium is 4% and the 20-30 year yield on risk free treasury bonds is 5%. Finally, assume the company has 1,000 shares of common stock outstanding. a. Use the CAPM to estimate the company’s equity cost of capital. • re = RF + β * (RM – RF) = 0.05 + 1.5 * 0.04 = 11% b. Compute the expected net distributions to stockholders for each future year. • D = NI – ΔCE = $1,100 – 0 = $1,100 c. Use the

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.

What is the correct capital structure and weighted average cost of capital for discounting the investment’s free cash flow?

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:

Thus the cost of capital can be easily calculated using the weighted average cost of capital formula (13.69%).

Assumptions need to be made for the Cost of Equity. We used the corporate rate of 11.766%

Weight of Equity = 71%; Equity Cost of Capital = 12%; Weight of Debt = 29%; Debt Cost of Capital = 4.55%

1. Please define Weighted Average Cost of Capital (WACC). Write down the WACC formula, and discuss its components.

This case study focuses on where financial theory ends and practical application of the weighted average cost of capital (WACC) begins. It presents evidence on how some of the most financially complex companies and financial advisors estimated capital costs and focuses on the gaps found between theory and application. The approach taken in the paper differed from their predecessors in several various respects. Prior published information was solely based on written, closed-end surveys sent to a large number of firms, without a focused topic. The study set out to see if financial theory, specifically cost-of-capital, is truly ubiquitous in true business applications.