Submitted By mark6241

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Words 1170

Pages 5

Weighted Average Cost of Capital WACC (and derived methods) and Adjusted

Present Value (APV)1.

For practical purposes, as is often the case of many larger firms in industrialized economies, whenever a target debt ratio is set up for the long term,

WACC and its associated methods might be an acceptable approximation.

However, the situation is different in a considerable number of instances:

The weighted average cost of capital (WACC) is a common topic in the financial management examination. This rate, also called the discount rate, is used in evaluating whether a project is feasible or not in the net present value (NPV) analysis, or in assessing the value of an asset. Previous examinations have revealed that many students fail to understand how to calculate or understand

WACC. WACC is calculated as follows:

WACC = E/V x Re + D/V x Rd x (1-tax rate)

WACC is the proportional average of each category of capital inside a firm – common shares, preferred shares, bonds and any other long-term debt – where:

Re = cost of equity

Rd = cost of debt

E = market value of the firm’s equity

D = market value of the firm’s debt

V = E + D = firm value

E/V = percentage of financing that is equity

D/V = percentage of financing that is debt

WACC is simply a replica of the basic accounting equation: Asset = Debt + Equity. WACC focuses on the items on the right hand side of this equation. (Most companies do not have preferred shares. For simplicity, we only use common shares and bonds in our illustrations.)

A firm derives its assets by either raising debt or equity (or both). There are costs associated with raising capital and WACC is an average figure used to indicate the cost of financing a company’s asset base.

In determining WACC, the firm’s equity value, debt value and…...

...elsewhere The cost of external equity capital (new stock issues) exceeds the cost of internal capital by the amount of issuance costs WACC and Its Importance Definitions The weighted average (by proportion of cost in the capital structure) of the after-tax cost of debt, the after-tax cost of preferred stock, and the cost of common equity All capital sources included Common stock Preferred stock Bonds Long-term debt Weighting of WACC components can be done at book value or market value Investors likely to prefer market value for equity because that’s closer to what they paid Sometimes use book value for weighting WACC components because Market value changes daily and the calculation is long Market value only readily available for publicly-held firms Especially for debt, market value may be unavailable Determines the rate of return that the firm must earn on its new investments to maximize its value WACC is appropriate for determining the return required on projects of average risk WACC is the discount rate used when computing NPV of a project of average risk WACC is the hurdle rate used in conjunction with the internal rate of return approach to project evaluation (for a project of average risk) WACC increases as beta and return on equity increase An increase in WACC notes a decrease in valuation and higher risk Since WACC is usually the benchmark for FUTURE projects, the MARGINAL cost of equity and/or debt should be considered Conclusion * *......

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...How to Calculate the WACC From a Balance Sheet | eHow.com Page 1 of 2 Print Article Discover the expert in you. How to Calculate the WACC From a Balance Sheet By Morgan Adams, eHow Contributor Weighted average cost of capital (WACC) is a calculation of a company's cost of capital, or the minimum that a company must earn to satisfy all debts and support all assets. The calculation includes the company's debt and equity ratios, as well as all long-term debt. Companies usually do an internal WACC calculation to assess overall company health. The larger and more complex a company is, the harder it is to determine WACC. Unfortunately, only some of the information needed to calculate WACC can be found on a balance sheet. Difficulty:Moderate Instructions Calculating WACC 1 Gather the required information from the balance sheet. Finding the information is the hardest step. Write out the full WACC equation and list the variables separately. It is a good idea to make a list of all your variables before rewriting the equation. WACC = [(E/V) * Re] + [(D/V) * Rd * (1-Tc)] Re= cost of equity (expected rate of return on equity) Rd = cost of debt (expected rate of return on debt) E = market value of company equity D = market value of company debt V = total capital invested, which equals E + D E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc = corporate tax rate Start calculating the variables. Start with cost of equity and......

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...CALCULATION of WACC for Quarter 2 (Based on the “Summary Data” from Sample Quarter 1) What is the market value of the capital raised by debt? (for debt, book value approx = market value) Short-term Loans Maturing $ 0 Intermediate Term Debt Maturing $1,850,000 Current Liabilities Bond Maturing $1,200,000 Intermediate Loans 2 year $ 937,500 3 year $ 0 Long Term Liabilities Bonds $1,200,000 Total Capital Raised by Debt $5,187,500 What is the market value of the equity? Multiply stock price ($37.49) times number of common shares (1,000,000) = $37,490,000 What is the market value of the debt + equity? $5,187,500 + 37,490,000= $42,677,500. What would be the annual after-tax cost for new long-term bonds? The cost of long term debt (Bonds) for quarter 2 will be 1.980% per quarter (this is found under Information for Future Quarters) which is 7.92% per year The after-tax cost is 7.92% x (1-0.4) = 4.75%/Yr What would be the after-tax cost of new short term loans? 1.616% x 4 = 6.46% x (1-.4) =3.88% / year What would be the after-tax cost to get more 2 and 3 year debt? (To keep things simple, just take an average of the cost of new 2 and 3 year debt, then reduce the cost by the tax shield): [1.698% + 1.784%] / 2 = 1.74% per quarter x 4 =6.96% per year x (1-.4) = 4.18% / year. (To be most correct you should take a weighted average, but a simple average is ok for our purposes) What is the cost of......

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...rejuvenate the company image, increase stagnant earnings, and to take back market share. By July, the share price for Nike had declined significantly to $42.09. During Nike’s analysts’ meeting, management stated their goals of 8% to 10% in revenue-growth and over 15% in earnings-growth. Analysts’ reviews were mixed on the new targets and the actual growth potential for Nike, so Kimi Ford and her new assistant, Joanna Cohen, are attempting to estimate Nike’s value. Due to the high sensitivity to the discount rate, we scrutinize the process Joanna used in calculating the Weighted Average Cost of Capital (WACC). The cost of capital is the required return expected by investors, based on the risks involved. WACC is calculated by summing the proportional market value cost of equity and debt. By determining WACC, investors can discount future cash flows of a company to find the intrinsic value. WACC is subjective to the estimates for the cost of equity, so we have to determine what method of finding the cost of equity is appropriate. To find the cost of equity, we can use one of three methods: Dividend-discount model (DDM), earnings-capitalization ratio, or the Capital-asset-pricing model (CAPM). The DDM is calculated by dividing the dividend of a company by the share price and adding its growth rate. This would be a good estimate if earnings growth was consistent, but it hasn’t been. Using the DDM, we calculated cost of equity to be 6.7%. This seemed too low for a growth......

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... ESTIMATING NPV The VP Operations used the discounted cash flow (DCF) model with NESA’s WACC assumed to be the same as those of our company’s at 14%. However, it fails to address the increased risk of a South African mining operations and the fact that this project is for the extraction of iron, not gold as is customary of New Earth Mining. The accounting officer also used a DCF model using a WACC of 24%, including a 10% added premium. This approach is more accurate than the previous one as the modified WACC incorporates elements of risk and is based on the discount rates used by similar companies in iron ore development. However, this assumption fails to consider the unique capital structure of NESA, which would change underlying assumptions regarding WACC, including the D/E ratio and the cost of debt ( ). For the external consulting firm, DCF is used with the difference that NESA is recognized as an independent subsidiary who bears no real similarities to the operations of New Earth Mining. As such, the WACC will be based on the unique capital structure of NESA (Appendix 2). NESA will have $160M of debt and $40M of equity. The cost of equity estimate at 24% is reasonable due to the increased risk and substantial leverage of the project. The of 8.88% can be estimated by dividing the weighted average of the interest rates on the debt. With this information, we calculated the WACC of 9.48%. This number is smaller than previous approaches, but it does not come as a......

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...Book Value VS Market value Weights You should always use the market value weights to calculate WACC. In practice, firms do use the book value weights. Generally, there will be difference between the book value and market value weights, and therefore, WACC will be different. WACC, calculate using the book value weights, will be understand if the market value of the share is higher than the book value and vice versa. Why do managers prefer the book value weights for calculating WACC? Beside the simplicity of the use, managers claim following advantages for the book value weights: Firms in practice set their target capital structure in terms of book values. The book value information can be easily derived from the published sources. The book value debt equity ratios are analyzed by the investors to evaluate the risk of the firms practice. The use of the book value weights can be seriously questioned on theoretical grounds. The component costs are opportunity rates and are determined in the capital markets. Te weights should also be market determined. The book value weights are based on arbitrary accounting policies that are used to calculate retained earnings and value of assets. Thus they are not reflecting economic values. It is very difficult to justify the use of the book value weights in theory. Market value weights are theoretically superior to book value weights. They reflect economic values and are not influenced by accounting policies. They are also...

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...Wal-Mart and Target WACC We computed the WACC for Wal-Mart and Target based on their most current financials. The weights of debt and equity were obtained from MorningStar.com. The risk free rate is the current rate for 30 year treasuries, and the cost of debt is the current 20 year rate on corporate bonds rated AA and A+. The tax rates were estimated by dividing the taxes paid from the operating income from Wal-Mart and Targets income statements. The market risk premium was obtained from the class, and is set at 5.5%. The betas and all other information were obtained from Google Finance. The goal of this project was to calculate different levels of WACC for Wal-Mart and Targets. We started by calculating the firms current WACC, and then a new WACC that had 50% more debt. To start, we had to calculate the firms cost of equity. We took the risk free rate and added it to the beta multiplied by the market risk premium. For example – Wal-Mart’s cost of equity was calculated as follows: Cost of Equity = 4.38% + .33(5.5%) We then calculated WACC by taking the weight of debt times the after tax cost of debt, plus the weight of equity times the cost of equity. We then increased debt by 1.5 for both companies, and re-levered their betas. After we re-levered the betas a new cost of equity can be calculated and then a new WACC is calculated. The results are typical, with WACC staying similar and the cost of equity rising. The following table shows Wal-Mart and Targets......

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...debts (bonds) $5,000,000 Total liabilities + equity = $10,000,000 1. Calculate the firm's WACC = 50% (4%)(1-40%) + 20%(12%) + 30%(6%) = .50(.04)(1-.40) + .20(.12) + .30(.06) = 0.012 + .042 = .054 or 5.4 % 2. If, as the firm's CFO, you wished to lower the WACC, make up a set of new dollar figures using different amounts of common stock, preferred stock, and long-term debt that would lower the WACC. Show the calculations to demonstrate that the new capital structure has a lower WACC than the original structure. Capital | Debt 60% | Equity 40% | Bonds | 4% | C. Stock (10) | 12% | tax | 40% | P. Stock (30) | 6% | Common stock $1,000,000 Preferred stock $3,000,000 Long-term debts (bonds) $6,000,000 Total liabilities + equity = $10,000,000 = 60%(4%)(1-40%) + 10%(12%) + 30%(6%) = .60(.04)(1-.40) + .10(.12) + .30(.06) = 0.0144 + .03 = .0444 or 4.44 % 3. Explain why you may want to lower the firm's WACC. By increasing the firm’s dept and contribution by the preferred stock holders, the WACC has decreased. A CFO may want to lower a firm’s WACC as an expressed desire to improve ROE. This can be done by the approval of more projects that were previously denied because the WACC was too high. Also, the lower the WACC the value of the firm increases. This also increases the stock value per share.......

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...5%) = 14.33% Cost of Capital = Cost of Equity (Risk Free Rate) + YTM (1- Tax Rate)(Debt Portion) = 14.33% (0.8) + 10% (1-0.4) (0.2) = 12.66% Therefore WACC = 12.66%. This value can be used to discount any project ii. The firm is proposing borrowing an additional RM200 million in debt and repurchasing stock. If it does so its rating will decline to A, with a market interest rate (yield to maturity) of 12%. What will the weighted average cost of capital be if they make this move? (3 marks) New Market Value of Equity = RM800 Million – RM200 Million = RM600 Million If the firm borrows RM 200 million repurchase stock, Equity will drop to RM 600 million New Debt/Equity Ratio = Debt Value / Equity Value = 400/600 = 0.67 Unlevered Beta = AVG Beta / (1+ Equity Portion * Old Debt Equity Ratio) = 1.15 / (1 + 0.6*0.25) = 1.00 New Beta = Unlevered Beta (1+Equity Portion * New Debt Equity Ratio) =1.00 (1+0.6*0.67) = 1.40 New Cost of Equity = Risk Free Rate + New Beta (Market Risk Premium Rate) = 8% + 1.40 (5.5%) = 15.70% New Cost of Capital = Cost of Equity (Risk Free Rate) + YTM (1- Tax Rate)(Debt Portion) = 15.70% (0.6) + (44/400) (1-0.4) (0.4) = 12.06 % Therefore WACC = 12.06% iii. Why do you think the company’s rating will decline with the move of stock repurchasing as mentioned in question 2(b) above? (3......

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...WACC Project On Amazon Due Date: January 16, 2016 Name: Professor Finding the weighted average cost of capital for Amazon.com Ticker: AMNZ Amazon is an American publically traded company and is one of the largest retailing firms headquartered in Seattle, Washington. The reason why I chose this firm is that it has equity, debt and lease payments in its capital structure. The following are the calculations performed in order to determine the WACC for the firm. Cost of debt According to Moody’s report for year 2014, the credit rating of Baa1 reflects excellent liquidity and financial policy for the shareholders (Moody, 2014). Even though the article reflected it to be a positive sign for the firm, still the rating is quiet low. Based on the financial statements of Amazon.com, if the firm has good credit ratings it must add 0.625% to the LIBOR rate in order to derive the cost of debt and if the rating is poor it must add 1% to the LIBOR rate (Amazon, 2014). I presume the credit rating to be extremely low so adopting a conservative approach, I have rather added 2% to the rate: The cost of debt for Amazon.com therefore is: KD= RF + spread KD= 0.561% + 2% KD = 2.561% For Amazon.com, the interest rate is the function of LIBOR rate so the book value approximately equals the market value. The estimated fair value of long-term debt is $9.981 billion ($9.1 billion for notes and $881 million for other long-term debt) as stated in the note 6 to the financial statements...

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..."equity risk premium", and is equivalent to the risk premium of the market as a whole times a multiplier--called "beta"--that measures how risky a specific security is relative to the total market. Thus, the cost of equity capital = Risk-Free Rate + (Beta times Market Risk Premium). 2. Capital structure. Next, we calculate the proportion that debt and equity capital contribute to the entire enterprise, using the market values of total debt and equity to reflect the investments on which those investors expect to earn a minimum return. 3. Weighting the components. Finally, we weight the cost of each kind of capital by the proportion that each contributes to the entire capital structure. This gives us the Weighted Average Cost of Capital (WACC), the average cost of each dollar of cash employed in the business. ...

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...Adjusted Present Value The adjusted present value ("APV") analysis is similar to the DCF analysis, except that the APV does not attempt to capture taxes and other financing effects in a WACC or adjusted discount rate. Recall from our discussion of DCF that the WACC used in the DCF analysis is calculated as a blend of the cost of debt and the cost of equity, thereby capturing the effects of taxes and financing. APV, on the other hand, seeks to value these effects separately. APV = base-case NPV + sum of PVs of financing side effects The APV method is not used as frequently in practice as is the DCF analysis, but more in academic circles. However, the APV is often considered to yield a more accurate valuation. Interest Tax Shields The most important financing side effect is the interest tax shield ("ITS"). When a company has debt, the interest it pays on that debt that is tax-deductible, creating interest tax shields that have value. In the DCF analysis, the ITS are baked in by including the tax-effected cost of debt in the WACC used to discount free cash flows ("FCF"). For APV purposes, the ITS in a given year is calculated as: ITS = Interest Expense × Tax Rate If the projected taxes to be paid exceed the ITS generated in a given year, the entire ITS is consumed in that year and no ITS carryforward is accumulated. However, if the company has more ITS in a given year than taxes paid: * The excess ITS can be carried back up to 3 years to offset taxable income in those...

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...must instead either use the CAPM model to calculate their cost of equity, or the Dividend-growth model. If they use the CAPM model, which is the most accurate, their cost of equity will be: .078+.8(.1625-.078)=14.56%. Or they can use the Dividend-growth model and their cost of equity would be: (2.7/63)+.1=14.29%. Both are acceptable but, because the Dividend-growth model is subjective, and the coupon rate (that PPC was originally using is a sunk cost, they should use the market rate). Thus using the market rate to calculate CAPM you use the Beta and market risk premium which are both based on the market rate and more accurate. Finally, their company WACC of 9% that they have calculated is incorrect and given the above calculations, their WACC using CAPM would be: [5.28(.5)+14.6(.5)]=9.94% and their WACC using Dividend-growth would be:.. Category: Business Autor: reviewessays 29 April 2011 Words: 780 | Pages: 4 Pioneer Petroleum Corporationâ€™s (PPC) has been through a diverse amount of changes throughout the years. They were originally were a merger of several different independent firms operating in the oil refining, pipeline transportation, and industrial chemicals fields. PPC then integrated vertically into exploration and production of crude oil and marketing refined petroleum products, but horizontally into plastics, agricultural chemicals, and real estate development. They decided to restructure the company into a hydrocarbons-based company,......

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... Step 3: Calculate the PV of the expected dividends: PVDiv = $2.40/(1.123) + $2.88/(1.123)2 = $2.14 + $2.28 = $4.42. Step 4: Calculate : = D3/(rs – g) = $3.08/(0.123 – 0.07) = $58.11. Step 5: Calculate the PV of : PV = $58.11/(1.123)2 = $46.08. Step 6: Sum the PVs to obtain the stock’s price: = $4.42 + $46.08 = $50.50. Alternatively, using a financial calculator, input the following: CF0 = 0, CF1 = 2.40, and CF2 = 60.99 (2.88 + 58.11) and then enter I/YR = 12.3 to solve for NPV = $50.50. Question 1. Rollins Corporation (RC) is estimating its weighted average cost of capital. (WACC). Its target capital structure is 20% debt, 20% preferred stock and 60% common equity. Its outstanding bonds have a 12% coupon rate, paid semiannually, a current maturity of 20 years, and sell in the marketplace for $1,000. RC could sell at par, $100 preferred stock that would pay a 12% annual dividend, and flotation costs of 5% would be incurred. RC’s beta is 1.2, the risk-free rate is 10% and the market risk premium is 5%. RC is a constant-growth firm that just paid an annual dividend of $2.00; its common stock currently sells for $27 per share, and has a growth rate of 8%. RC’s policy is to use a risk premium of 4% when using the bond-yield –plus premium method to find the cost of equity. RC’s marginal tax rate is 40%. PLEASE SHOW......

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...According to our text the r above the little e is the required return for equity, and the r above the d is the required return for debt. L is the market value proportion of debt financing and T is the marginal corporate tax rate on income for the proposed project. In word format the equation states that WACC is the equity of the firm divided by the debt plus equity times the required return of equity plus the debt divided by the debt plus equity times one minus the marginal corporate tax rate on the project times the required return for debt. This should equal one minus the market value proportion of debt financing times the required return for equity plus the market value proportion of debt financing times one minus the marginal tax rate times the required return for debt. The WACC is expressed as an after-corporate-tax- return because investors are paid after the corporate taxes are. Furthermore, in regard to equity is also an after corporate tax return (Emery, Finnerty & Stowe, 2007). To use the WACC one must understand the purpose is twofold. First as a measure to ensure that the financial obligation of the company is being held to a certain set of standards. The end goal of the WACC is to generate capital for those who hold stake within the company. When these numbers are not reflected are there are measured losses this is how the company can see that changes need to be made to shift in a profitable direction....

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