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The assignment is to estimate the weighted average cost of capital (WAC) for an actual corporation as of the current time. Actual managers would need to know their company’s WAC as a starting datum to estimate the discount rate to use in the net present value analysis of new projects or of termination decisions. The student will later need to know the technique for application in some case study solutions.
The project also develops student skills in using elementary financial management models, in dealing with situations where there are too much or too little data, in employing publicly available data sources, and in working around naturally occurring measurement errors. The Primary Equations The theory of why managers should use WAC in net present value analysis comes later in the course. For now, start with the equations for WAC, per SE: aka = eke(EN) + kid(l – + kip(PAN) + kill(LEN) The symbol, aka, is the same as WAC. V is the total market value of the corporation. The identities of all other symbols are in the paragraphs below.
Note from the beginning that all variables are estimates of market values – these are not the same s accounting book values nor the coupon rates, except under extraordinary circumstances. [l] l. Format 1. An important feature of your submission is your list of assumptions. 2. Your report will have no extended textual part; I. E. , no long paragraphs. 3. Your report must Include Tour or Delve pages AT documentation. I nose wall De copies AT data sources with yellow (or pick you favorite color) highlighting of the datum you used. Handing in 50 pages of documentation can only hurt your professor’s sore elbow and your grade. . One essential page of documentation is a page detailing the nature f the corporation’s debt ? more on this page below. 5. The format I use in my numerical example is a good one, but it’s not required. The data are from December 2009. II. Picking Your Corporation 1. Each person should pick different corporation. This is not a group project. 2. Avoid public utilities (PL, telephone company, etc. ). Because of regulation, their WAC have a different meaning. Also, their capital structures include many issues of debt, making the project tedious. 3. Avoid financial companies (banks, insurance companies, brokers, etc. . Because of regulation, their capital structures are difficult o discern from their financial structures. One needs more expertise than you have to deal with their WAC.
When you think you have a good subject corporation, the first thing to search for is a page detailing the nature of the company’s debt and/or leases and/or preferred stock. There is an automatic 10-point penalty if this page is not in your documentation. The page should have some detail about each instrument’s coupon rate, maturity date, and face value. One source of this page is the notes to the financial statements from the corporation’s annual report. A very good way to find this page is in a ASK report where the annual report is subsumed. A less detailed source is Emergent[2] Online (available through the FAA library Bessie). 3] If Merger’s lists your company, click “Long Term Debt” for debt details and rating, if any.
Does it have preferred stock, P (possible, but not likely; these days most preferred stock is convertible)? Does it have leasing, L, (capital leases appear on the liability side of the balance sheet, and operating leasing appears in the debt information sheet)? [4]Repeating, it’s O. K. For one or more of these variables to be zero, dropping a term out of equations [1] and For our Black & Decker example, we see find it has debt, leases [via a search of the notes to financial statements in the ASK] and common stock. Table 2 I Black & Decker: February 19, 2009 Operating Lease Payments 1 12009 169. 8 150. 1 1 12010 1 12011 1 12013 I I Thereafter 17. 3 116. 8 1192. 3 ‘V. Estimate the Marginal Cost of Capital for Each Component 1. Marginal Cost of Debt: You must estimate the marginal cost of each component of capital that is currently in your corporation’s capital structure. The starting point is the marginal cost of borrowing, regardless of whether the corporation has any debt in its capital structure. This is an estimate of the interest rate the corporation would have to pay on new borrowing. 5] Since the application of WAC is in the analysis of long-term projects, the appropriate interest rate to use is that of long-term borrowing.
First, try to find your corporation’s debt rating, maybe using Google. The majority of corporations are not rated, and thus you probably will assume a rating. For example, a corporation with a history of steady, positive earnings would have a rating of AAA or better[6]. A history of erratic but nearly always positive earnings could merit a rating of about Baa. A history of erratic, sometimes negative earnings, would be consistent with low ratings such as B or Baa. Armed with the rating, use a table that shows an index [the typical interest rate] versus the rating.
There are scores of methods for estimating eke; I present three poor ones. Nevertheless, they are the best three available. A. The Risk Premium Method An investor can earn a relatively low-risk return of kid via your corporation’s debt. In order to persuade the investor to buy your corporation’s riskier equity, the investor must expect a higher return, p. Thus, eke = kid + p Here, p, is a subjectively estimated risk premium: given that an investor in your corporation can with some safety earn kid investing in debt, how much more should the investor expect to earn from investing in your corporation’s risky equity?
Experience has shown that p ranges from 0. 02 to 0. 10. In the Black & Decker example calculation, the last 11 years have shown growth in revenue until the 2008 recession. Despite the recession, B has had positive operating and net earnings. My estimate is to set p = 0. 05, below the middle of the range. Applying equation [3] yields: Q = 0. 0714+0. 050=0. 214 b. The dividend capitalization or Gordon model eke = dips(l+g)/p + g In this model, dips, is annual dividend per share, p is the current common stock price and g is the anticipated growth rate of dividend far into the future.
The former two variables are easy to find (Table 3). One usually estimates g via some observed historical growths in the company (Table 3 – but these are substantially negative) ? note that these observed growth rates are sometimes “NINA;” sometimes negative and thus useless; and sometimes so high as to be unsustainable. Likewise the positive ones nave great variability Nevertheless, you must use your Judgment to apply available data in making a g estimate. If dips = O, you should omit this model. Suppose for Black & Decker, you pick the 10-year forecast growth in peps at 0. 3 [yahoo. Com/finance, Analysts’ Estimates]. Equation [4] yields: eke = + 0. 03 = 0. 032 This is an example of a nonsense estimate because markets demand that eke > kid. You must ignore this kind of estimate. Another notion about using equation [4] is to employ the industry average for g (Table ???? ) For example, suppose you choose the industry average growth for earnings at 0. 0997. Now equation [4] gives: e = + 0. 0997 = 0. 1071 This estimate is plausible. C. The Capital Asset Pricing model eke = ref+ џ(km – ref) Experts disagree on what to use to the first riskier rate,