AFM373 Lecture Notes - Lecture 6: Net Present Value, Cash Flow, Market Risk

68 views2 pages

lilacmouse857

3 Jul 2018

School

University of Waterloo

Department

Accounting & Financial Management

Course

AFM373

Professor

Neil Brisley

For unlimited access to Class Notes, a Class+ subscription is required.

Nike case

What is the WACC, conceptually?

Cost of capital (equity + debt) to the firm

rD = required return for the bondholders to match the risk.

Takes in account of the opportunity cost because investors can get stable returns from a

bank, government treasury bonds, etc.

rE = required return as well for shareholders to evaluate their investment in the company

From the firm's POV, it is the cost

The required return for the investors are forward looking.

Investors in the market sets the WACC

Investors evaluate the two risks

Risks of the cash flow that we are generating (business risks)

Risks of the capital structure (financial risks)

WACC is used to valuate the individual projects the firm takes on, and also the valuating the

whole firm with free cash flows

How is WACC calculated?

What Joanna did in the case for kd is estimating past debt which is not good.

In theory, we should use the going forward tax rate.

Beta = 1 for market

We want the forward looking MRP but its hard to measure. So we used a historical MRP with

geometric rate.

For beta, use either the average or the most recent YTD beta. Different arguments for both.

We want market value of enterprise value (both debt and equity)

Book value of debt is often very close to market value.

To find the market rate of debt, use the book value and x 0.96

For a private corporation, its hard to find the value of equity

Why deduct cash to get net debt? If not, why?

If we believe that cash is not needed, then we can use it to paydown debt. Only if it is

excess cash.

find more resources at oneclass.com

Unlock document

This preview shows half of the first page of the document.
Unlock all 2 pages and 3 million more documents.

Already have an account? Log in

Document Summary

Cost of capital (equity + debt) to the firm rd = required return for the bondholders to match the risk. Takes in account of the opportunity cost because investors can get stable returns from a bank, government treasury bonds, etc. re = required return as well for shareholders to evaluate their investment in the company. From the firm"s pov, it is the cost. The required return for the investors are forward looking. Risks of the cash flow that we are generating (business risks) Risks of the capital structure (financial risks) Wacc is used to valuate the individual projects the firm takes on, and also the valuating the whole firm with free cash flows. What joanna did in the case for kd is estimating past debt which is not good. In theory, we should use the going forward tax rate. We want the forward looking mrp but its hard to measure. So we used a historical mrp with geometric rate.

Related Questions

I need help proof reading my assignment please, thank you in advance.

Cost of Debt

The cost of debt is the effective rate that a company pays on its total debt.

As a company acquires debt through various bonds, loans and other forms of debt, the cost of debt is a useful metric. It gives an idea as to the overall rate being paid by the company to use debt financing. This measure is also useful because it gives investors an idea as to the riskiness of the company compared with others. The higher the cost of debt, the higher the risk.

1. Cost of debt (before tax) = Corporate Bond rate of companyâs bond rating.

Pepsico 2.75% = 2.75%

Current cost of Debt as of February 17th 2014 = 2.75%

2. Current tax rate

In 2013 PepsiCoâs tax rate was = 23.66%

2013 PepsiCo averaged tax rate of 23.66%

3. Cost of Debt (After Tax) = (Cost of Debt Before Tax) (1 â Tax Rate)

The effective rate that a company pays on its current debt after tax.

.0275 x (1 â .2366) = Cost of debt after tax

The cost of debt after tax for PepsiCo is 2.10%

Cost of Equity or R Equity = Risk Free Rate + Beta Equity (Average Market Return â Risk Free Rate)

The cost of equity is the return a firm theoretically pays to its equity investors to compensate for the risk they undertake by investing in their company.

Risk Free Rate = U.S. 10-year bond = 2.74%

Average Market Return 1950 â 2014 = 7%

Beta = PepsiCoâs Beta = 0.37

Risk Free Rate + Beta Equity (Average Market Return â Risk Free Rate)

2.74 + 0.37 (7- 2.74)

2.74 + 0.37 x 4.26

2.74 + 1.58 = 4.31%

Currently, PepsiCoâs has a Cost of Equity or R Equity of 4.31%, so investors should expect to get a return of 4.31% per-year average over the long term on their investment to compensate for the risk they undertake by investing in this company.

Weighted Average Cost of Capital or WACC calculation

The WACC calculation is a calculation of a companyâs cost of capital in which each category of capital is equally weighted. All capital sources such as common stock, preferred stock, bonds and all other long-term debt are included in this calculation.

As the WACC of a firm increases, and the beta and rate of return on equity increases, this is an indicator of a decrease in valuation and a higher risk. By taking the weighted average, we can see how much interest the company has to pay for every dollar it finances. For this calculation, you will need to know the following listed below:

Tax Rate = 23.66%

Cost of Debt (before tax) or R debt = 2.75%

Cost of Equity or R equity = 4.31%

Debt (Total Liabilities) for 2013 TTM or D = $53.069 billion

Stock Price = $78.09 (Feb. 17th, 2014)

Outstanding Shares = 1.55 billion

Equity = Stock price x Outstanding Shares or E = $121.04 billion

Debt + Equity or D+E = $174.109 billion

WACC = R = (1 â Tax Rate) x R debt (D/D+E) + R equity (E/D+E)

(1 â Tax Rate) x R debt (D/D+E) + R equity (E/D+E)

(1 â .2366) x .0275 x ($53.069 /$174.109) + .0431 ($121.04 /$174.109)

.7634x .0275 x .3048 + .0431 x .6972

.0064 + .03

= 3.64%

Based on the calculations above, we can conclude that PepsiCo pays 3.64% on every dollar that it finances, or 3.64% cents on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.0673 plus the cost of the investment for the investment to be feasible for the company.

Understanding the WACC of a company is important because securities analysts employ WACC all the time when valuing and selecting investments. In discounted cash flow analysis, for instance, WACC is used as the discount rate applied to future cash flows for deriving a businessâs net present value.

Investors use WACC as a tool to decide whether to invest. The WACC represents the minimum rate of return at which a company produces value for its investors. Letâs say a company produces a return of 20% and has a WACC of 11%. That means that for every dollar the company invests into capital, the company is creating nine cents of value. By contrast, if the companyâs return is less than WACC, the company is shedding value, which indicates that investors should put their money elsewhere.

Question 2

If you calculated WACC for a firm, in what order (from largest to smallest) would you expect to see WACC, cost of equity (re), and cost of debt (rd)? All rates are after taxes, and assume that the firm operates at its target capital structure.

re > rd > WACC.

re > WACC > rd.

WACC > re > rd.

rd > re > WACC.

WACC > rd > re.

Question 3

Andresson Inc. has no debt, and it has two equally-sized divisions. Division A's cost of capital is 10.0%, Division B's cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division A's projects are equally risky, as are all of Division B's projects. However, the projects of Division A are less risky than those of Division B. Which of the following projects should the firm accept?

The Division A project with a 9% return.

The Division A project with a 11% return.

The Division B project with an 11% return.

The Division B project with a 13% return.

The company-wide project with an 11% return.

Question 4

Which of the following statements is CORRECT?

A change in a company's target capital structure cannot affect its WACC.

WACC calculations should be based on the before-tax costs of all the individual capital components.

Flotation costs associated with issuing new common stock normally increase the WACC.

If a company's tax rate decreases, then, all else equal, its weighted average cost of capital will decline.

An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing.

Question 5

A company's perpetual preferred stock currently sells for $98.50 per share, and it pays an $7.00 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 8.00% of the issue price. What is the firm's cost of preferred stock?

7.72%

8.22%

8.83%

9.10%

9.40%

Question 6

O'Henry Inc. has a beta of 1.15 and a tax rate of 30%. The risk free rate of interest is 5.00%; and the market rate of return expected on equity securities is 13.00%. What is the firm's cost of common equity based on the CAPM?

11.30%

12.35%

14.20%

15.35%

17.06%

Question 7

Muller Co. just paid a dividend of $0.60 on stock that is trading at $27.50 per share. They expect a growth rate of 8.00% (constant). Flotation costs are 5%. What is the cost of common equity based on the DCF approach?

9.42%

9.91%

10.48%

10.71%

11.51%

Question 8

A company issues bonds that yield 8.75% to investors with a after-tax cost of debt of 6.1%. Economists estimate the judgmental risk premium at 8.65%. What is an estimate of the company's cost of common equity?

12.59%

13.10%

14.63%

15.60%

17.40%

greysalmon790

F2 Q1-5

The return on equity of a typical firm may change over time because of changes in business and economic conditions, but it is unlikely to change based on the financing or capital structure of the firm.

a. False.

b. True.

Your firm has been plodding along without much attention from the stock market. Your boss insists that he can (a) increase the return on assets to shareholders by taking on more debt, and (b) attract new investors to the firm due to the higher returns.

a. False.

b. Partly true, partly false.

c. True.

Even in a world with no frictions â that is, taxes, costs of bankruptcy, asymmetric information â debt will always be preferred because cost of debt is always lower than cost of equity for a firm.

a. True.

b. False.

c. Partly true, partly false.

In a world with taxes and bankruptcy costs, and in which interest on debt is tax deductible, if a firm has some debt:

a. The return on equity is less than the weighted average cost of capital (WACC).

b. The return on equity is greater than the weighted average cost of capital (WACC).

c. The relationship between return on equity and the WACC cannot be determined because it depends on several factors.

In the real world, where there are taxes and interest on debt is tax deductible, if two firms have the same cash flows as each other in all possible scenarios in the future, the returns on equity of the two firms will:

a. Will depend on the capital structures adopted by the firms.

b. Will depend on the capital structures adopted by the firms and the valuation method used.

c. Always be equal to each other.

d. Will depend on the method of valuation used.

AFM373 Lecture Notes - Lecture 6: Net Present Value, Cash Flow, Market Risk

Document Summary

Get access

Related Documents

AFM373 Lecture Notes - Lecture 2: Sneakers, Sensitivity Analysis, Dividend Discount Model

AFM373 Lecture Notes - Lecture 7: Asset Turnover, Nopat, Capital Structure

AFM373 Lecture Notes - Lecture 4: Risk Premium, Sports Equipment, Capital Asset Pricing Model

Related Questions