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Words 1017

Pages 5

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 debt or equity. WACC is the average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it finances.

A firm's WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company…...

...1. If a corporation has an average tax rate of 40 percent, what is the approximate, annual, after-tax cost of debt for a 15-year, 12 percent, $1,000 par value bond, selling at $950? Flotation costs are 1% of face value. The interest payments are semi-annual. PV = 950 – (1000*.01) = 940, FV = -1000, PMT = 120/2 = -60, N = 15 x 2 = 30, I = ? Before tax cost of debt = 6.46 x 2 = 12.92% After-tax cost of debt = 12.92(1-.4) = 7.75% 2. A firm has issued 10 percent preferred stock, which sold for $100 per share par value. The cost of issuing and selling the stock was $2 per share. The firm's marginal tax rate is 40 percent. What is the cost of the preferred stock? Cost of preferred = 10/(100-2) = 10.2% 3. A firm has a beta of 1.2. The market return equals 14 percent and the risk-free rate of return equals 6 percent. What is the estimated cost of common stock equity (retained earnings)? Cost of RE = 6 + (14-6)1.2 = 15.6% 4. A firm has determined its optimal capital structure which is composed of the following sources and target market value proportions. Debt: The firm can sell a 12-year, $1,000 par value, 7 percent bond for $960. A flotation cost of 2 percent of the face value would be required in addition to the discount of $40. The coupon payment is semi-annual. Additionally, the firm's marginal tax rate is 40 percent. Preferred Stock: The firm has determined it can issue preferred stock at $75 per share par value. The stock will pay a $10...

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...NIKE, INC. COST OF CAPITAL Context: Estimating Cost of Equity with different methods. Compute WACC Nike’s current price per share= $ 42.09 Question: Is it undervalued or overvalued to make buy /sell decision? Forecasts for Cash flows, Dividend growth, EPS estimates for NIKE are given. Interest rate #’s, Betas, Book values on debt and equity are given. Also historical performance #s are given. At 12% WACC Nike is overvalued and hence sell decision; At 11.17% correct valuation; WACC below 11.17% , undervaluation and hence buy decision. Exhibit 2 : The bottom table shows the sensitivity of share price to discount rate. The issue is which discount rate (WACC) to use to make the decision. Lower the discount rate, higher the estimate of stock price. How do you estimate WACC? Weights of Debt and Equity Cost of Debt and Cost of Equity Overall Assessment of the firm: Exhibit 1 Uneven growth rate in revenue, operating income and net income from negative to low positive. All profit margin #s are relatively stable. Market share has declined. Company’ plans: (1) New Products in shoes and Athletic Apparel; (2) Expense Control Revenue growth target= 8-10% Earnings growth target=15% Both are substantially higher than the recent performance. Methodologies for Valuing a Firm 1. Estimating Cash flows per share; Take a good look at Exhibit 2. Exhibit 2 has information for ten years. Question: Why is terminal value given at the end of year...

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...THE COST OF CAPITAL The investor-supplied items- debt, preferred stock, and common equity- are called capital components. Increases in assets must be financed by increases in these capital components. The cost of each component is called its component cost. For example, Allied can borrow money at 10%, so its component cost of debt is 10%. These costs are then combined to form a weighted average cost of capital, which is used in the capital budgeting process. rd interest rate on the firm’s new debt = before-tax component cost of debt. It can be found in several ways, including calculating the yield to maturity on the firm’s currently outstanding bonds. rd(1-T) after tax component of debt, where T is the firm’s marginal tax rate. rD(1-T) is the debt cost used to calculate the weighted average cost of capital. The after-tax cost of debt is lower than the before-tax cost because interest is deductible. rp component cost of preferred stock, found as the yield investors expect to earn on the preferred stock. Preferred dividends are not tax-deductible, hence, the before- and after-tax costs of preferred are equal. rs component cost of common equity raised by retaining earnings, or internal equity. It is also defined as the rate of return that investors require on the firm’s common stock. Most firms, once they have become well established, obtain all of their new equity as retained earnings, hence, rS is their cost of all new equity. re component cost of...

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... = = 2.594 or, 1 + g = (2.594)1/10 or, g = 1.10 - 1 = 0.10 or 10% b. Calculation of flotation cost in percent Flotation cost in percent = = = 0.10 or 10% c. Cost of retained earning (ks) = = = 0.1951 or 19.51% d. Cost of external equity (ke) = + g = = 0.2057 or 20.57% Illustration 5 Compute the after-tax cost of the following, assuming that a firm has a tax rate 30 percent: a. A bond, sold at par, with a 10.4 percent coupon. b. A preferred stock, sold at Rs 100 with a 10 percent coupon and a call price of Rs 110, if the company plans to call the issue in 5 years c. A common stock selling at Rs 16 and paying a Rs 2 dividend, which is expected to be continued indefinitely. d. The same common stock if dividends are expected to grow at the rate of 5 percent per year and the expected dividend in year 1 is Rs 2. e. Compute weighted average cost of capital by using the component cost of capital computed above in (a), (b) and (d) if the firm has 30 percent debt, 20 percent preferred stock, and the balance common stock. Solution GIVEN, Tax rate (t) = 30% a. After-tax cost of bond (kdt) Coupon interest rate = 10.40% kdt = kd (1 - t) = 10.40% (1 - 0.30) = 7.28% b. Cost of preferred stock (kPS) Call price = Rs 110...

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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...

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...Cost of Capital Introduction This paper examines key elements of a cost of capital policy to facilitate objective management and allocation of corporate funds. In order for a company to make long-term investments to grow, whether that is new equipment, new products or other assets, managers must be aware of the cost of acquiring any of these assets. The obvious objective for these managers is to earn more than the cost of capital and in doing so will increase their company’s market value. If they fail to adequately estimate their cost of capital and their long-term investments fall beneath the cost of capital, their company’s market value will decline as a result. This ongoing battle of managing and calculating the cost of capital and how to budget them accordingly is extremely important in providing the necessary goals of increasing value to their company’s stockholders. The information that managers use will ultimately dictate the outcomes of their company’s cost of capital policy and how the allocate corporate funds. This paper will highlight several processes and elements managers use in determining capital cost. Functions for Decision Making When corporate managers think about the cost of capital and cost allocation, there are several factors that must be analyzed and weighed. First, managers need to look at the general economic condition for their industry as well as overall market. These would include the demand and supply of capital within the economy, and...

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...NIKE, INC.: COST OF CAPITAL The cost of capital represents the minimum return required by providers of finance for investing in an asset, it may be a project, a business or strategic unit or an entire company. It needs to represent the capital structure used to finance the investment and therefore likely to include cost of equity and debt. The cost of capital also represents a “hurdle rate” that a company’s projects must exceed in order to increase shareholders wealth and is used as a discount rate in net present value (NPV) investment appraisal techniques. Projects that generate a positive NPV at the cost of capital are accepted since they earn more than the investors required rate of return. Projects which generate a negative NPV are rejected as they earn less than their target rate of return. The cost of capital therefore plays a vital role in corporate finance, establishing a link between investment decisions and finance decisions i.e what companies should be spending their money on and how this should be funded. The weighted average cost of capital (WACC) represents the overall cost of capital for a firm, incorporating the cost of debt, equity and preference share capital, weighted according to the proportion of each source of finance within the business. In arriving at the WACC for a firm, the models used to calculate the cost of each source of finance assume that the required rate of return is a function of the shareholders’ expectations of future......

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...What is he WACC and why is it so important to estimate a firms cost of capital? The WACC (weighted average cost of capital) is a percentage figure resulting from a calculation method by which the adequate cost of capital of a firm is expressed. It considers the composition of a company’s funding, be it debt or equity. A corporation whose source of funding is equity by 100 percent will have a WACC equal to the cost of equity. By contrast, a levered company will have to reflect the cost of debt as well. The WACC takes their respective quantitative contributions to the entire amount of funding, serving hence as an allocation base, into account. As there is a direct relationship between the two portions, debt and equity, in order to calculate a proper overall price, they must be multiplied with their respective single prices. What is crucial in the calculation process is that one must not omit the tax shield effect caused by debt. Which is, due to fiscal regulations, that all interest expenses which occur in the financing process are tax deductible and, hence, reduce the overall result. This circumstance is mathematically reflected by inserting the term (1-tc). Tc here stands for the corporate tax rate, which, as in the NIKE case, needs adjustment for any taxes imposed by particular states. So if a company faces 38% corporate tax rate the remaining part of 62% count as an expense. Again, as there is a direct relationship to the proportion of the debt and its cost, the higher...

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...Calculation of cost of debt by using IRR method : Formula : B0=I*t=1n11+rd t +M*11+2dn=I*PVIFA r d,n+M*PVIFrd,n B0=Value of the bond at time zero I= annual interest paid in dollars n=number of years to maturity m=par value in dollars rd=required return on bond B0=$956 Coupon Rate =13.5% I= coupon payment=13.5%*1000 = 135 Year to maturity =n=25 years Par value =1000 A trial –and – error technique: At the first consider rd=7.58%equal to method one and B0=$956 I= coupon payment=$135 1)The first try: 956=135*t=1251(1+7.58%)t +1000*(1(1+7.58%)25) 956= 135*(PVIFArd,n) +1000*(PVIFArd,n) From table A-4 and A -2 (Appendix A) r=7.58%, n=25 PVIFArd,n=11.164 1000*(1(1+7.58%)25)=1000*0.161=161 135*11.164=1507.1 956≠1507.1+22.3 2)Another try rd=0.10 956=135*t=1251(1+10%)t +1000*(1(1+10%)25) PVIFArd,,n=9.077 135*9.077=1225.4 1000(1(1+10%)25)=0.092 PVIFrd,n=0.092 ,1000*0.092=92 956 ≠ 1225.4 +92 3)An other try: rd:=12% PVIFArdn=7.843 PVIFrdn=0.059 135×7.843=1058.9 1000×0.059=59 956≠1058.9+59 4) An other try: rd=%14 PVIFArdn=6.873 PVIFrdn=0.038 135×6.873=927.9 1000×0.038=38 927.9+38=965.9 956≠965.9 5)An other try: rd=%14.2 PVIFArdn=6.791 PVIFrdn=0.036 135×6.791=916.8 1000×0.036=36 916.8+36=952.6 956≠952.8 6)An other try: rd=%14.15 PVIFArdn=6.810 PVIFrdn=0.037 135×6.81=919.3 1000×0.037=37 919.3+37 = 956.3 959=956.3 rd=%14.15= cost of debt=correct answer...

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...Nike Cost of Capital I. Single of Multiple Costs of Capital Since Nike has multiple business segments it is appropriate to question whether to use single or multiple costs of capital for the analysis. Kimi’s assistant Joanna went ahead and chose to use one cost of capital for Nike. We agree with her decision because Nike’s different segments are all generally sports related and are susceptible to the same market risks. For example, Nike’s footwear and apparel lines, which make up a combined 92% of their revenue, are segments that complement each other and are sold through the same marketing and distribution channels. Non-Nike products made up only 4.5% of Nike’s revenue including the Cole Haan brand, a company that sells casual dress and footwear products. Since the Cole Haan is the only business segment that took on different risks than the others and since it makes up such a tiny fraction of the revenues, its impact on the decision is insignificant so one cost of capital should be used for the whole company. II. Methodology for Calculating Cost of Capital Joanna is correct to use the WACC method for computing the costs of capital. However, her estimation of the proportion of debt to equity is incorrect because she uses book values from the past instead of using the current market values. The reason why we must use the current market value of debt and equity is so that the estimate of Nike’s present day WACC is as accurate as possible. Using book values, even though...

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... diversification. CAPM accounts for the company’s level of systematic risk relative to the stock market as a whole. By using the systematic risk, CAPM reflects reality instead of using unsystematic risk. A reasonable and simple prediction is given when using CAPM since it eliminates unsystematic risk. This advantage makes the capital asset pricing model a better approach when estimating the cost of equity. The only disadvantage with CAPM is that it is difficult to estimate betas for many projects. CAPM provides a reasonable estimation, not exact numbers. The second model used to estimate the firms cost of equity is the Dividend Discount Model (DDM). The Dividend Discount Model has many advantages but many disadvantages, too. Dividend Discount Model is useful because it allows significant flexibility when estimating future dividend streams. Furthermore, DDM allows for sensitivity testing and analyzing market reactions to changing circumstances. Also, it gives the investors the option to suit their model to their expectations rather than force-fit assumptions into the model. DDM is difficult to estimate because it requires three terms to be estimated – the growth rate, dividend per share, and the current stock price. Out of the three above, the growth rate is the most difficult to estimate. DDM expects dividends to grow at a constant rate and will only work if the firm makes payouts in the form of dividends. Given that this is not the case for Nike, we did not favor this...

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...Case Study: Nike, Inc.: Cost of Capital BUSFIN 4214 Written By: Joe Nau Nau.33@osu.edu Section: 32347 Cost of Capital NorthPoint Group’s strategy consists of identifying and investing in undervalued public companies. Joanna Cohen, an assistant to a portfolio manager at NorthPoint, is asked to help evaluate whether Nike Inc. is undervalued. Analysis by the portfolio manager shows that when Nike’s cash flows are discounted at 12% their shares are overpriced, however, when discounted at rates below 11.17% the firm is undervalued. Cohen is tasked to further analyze Nike’s cost of capital to accurately estimate what rate their cash flows should be discounted back at. Joanna Cohen’s WACC Calculations Cohen decides to use a single cost of capital rather than multiple costs of capital. This is accurate as Nike operates primarily in the same business segments and each segment assumes similar risks. To find Nike’s Weighted Average Cost of Capital (WACC), she must first find the capital structure of the firm. Cohen incorrectly uses the book value of equity, rather than the market value. Additionally, she uses the book value of debt, however this is acceptable because the market values are not provided in the case. With Nike’s capital structure in hand, Cohen begins calculate the cost of capital for debt and equity. To calculate the cost of debt, Cohen uses historical interest expenses as a proxy, however this is not a forward looking estimation and using the materials...

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...Cost of Capital Calculating Cost of Capital: * Component Costs * Capital Structure Component Costs: * Cost of debt – R d * Cost of preferred stock – R p * Cost of equity – R e Component Cost of Debt (R d) * Loan: R d = Effective Annual Rate of Loan. EAR=1+APRmm-1 * Bond: R d = YTM. P0=c×1Rd-1Rd(1+Rd)t+FV(1+Rd)t Where: “c” is dollar coupon; “FV” is Face or par value, which is $1,000; “t” is remaining years to maturity. “P 0” is current market price of bond. Note: If the bond pays semi-annual coupon, divide “C” by 2; multiply “t” by 2; and multiply answer (R d) by 2. * Cost of Preferred Stock (R p): Rp=DIVPSP0 Where: DIV is $ preferred stock dividend; or dividend yield x PAR. P 0 is current market price of preferred stock. Note: Par value of preferred stock is $100. * Cost of Equity (Re) 1. Discounted Cash Flow Model (DCF model) Re=D1P0+g Where: D 1 is next period expected dollar dividend of common stock. Or, D1=D0 x (1 + g). “g” is constant dividend growth rate of common stock. P0 is current market price of common stock. 2. Capital Asset Pricing Model (CAPM) Re=Rf+E(Rm)-Rf×β Market Risk Premium Market Risk Premium Where: R f is risk-free rate. E(R m) is expected return on market. is beta of company. Estimating beta: Rstock=c+β×Rmarket+e Capital Structure: * Debt * Long-term debt * Interest-bearing short-term debt used to finance long-term assets...

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...COST OF CAPITAL The Marietta Corporation, a large manufacturer of mufflers, tailpipes, and shock absorbers, is currently carrying out its financial planning for next year. In about two weeks, at the next meeting of the firm's board of directors, Frank Bosworth, vice president of finance, is scheduled to present his recommendations for next year's overall financial plan. He has asked Donna Botello, manager of financial planning, to gather the necessary information and perform the calculations for the financial plan. The company’s divisional staffs, together with corporate finance department personnel, have analyzed several proposed capital expenditure projects. The following is a summary schedule of acceptable projects (defined by the company as projects having internal rates of return greater than 8 percent): Project Investment Amount Internal Rate of Return (in Millions of Dollars) A $10.0 25% B $20.0 21% C $30.0 18% D $35.0 15% E $40.0 12.4% F $40.0 11.3% G $40.0 10% H $20.0 9% All projects are expected to have one year of negative cash flow followed by positive cash flows over the remaining years. In additions, next year’s projects involve modifications and expansion of the company’s existing facilities and products. As a result, these projects are considered to have approximately the same degree of risk as the company’s existing assets. Botello feels that this summary schedule and detailed supporting documents provide her with the necessary...

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...With trillions of dollars in cash sitting on their balance sheets, corporations have never had so much money. How executives choose to invest that massive amount of capital will drive corporate strategies and determine their companies’ competitiveness for the next decade and beyond. And in the short term, today’s capital budgeting decisions will influence the developed world’s chronic unemployment situation and tepid economic recovery. Although investment opportunities vary dramatically across companies and industries, one would expect the process of evaluating financial returns on investments to be fairly uniform. After all, business schools teach more or less the same evaluation techniques. It’s no surprise, then, that in a survey conducted by the Association for Financial Professionals (AFP), 80% of more than 300 respondents—and 90% of those with over $1 billion in revenues—use discounted cash-flow analyses. Such analyses rely on free-cash-flow projections to estimate the value of an investment to a firm, discounted by the cost of capital (defined as the weighted average of the costs of debt and equity). To estimate their cost of equity, about 90% of the respondents use the capital asset pricing model (CAPM), which quantifies the return required by an investment on the basis of the associated risk. But that is where the consensus ends. The AFP asked its global membership, comprising about 15,000 top financial officers, what assumptions they use in their financial...

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