1. Consider the following data regarding the cost of capital of an italian auto manufacturing firm: * Capital structure includes 40% debt
* Industry average unlevered beta is 1.8
* 10 year Italian Government bond yield is at 4.5%
* JP Morgan has issued an estimate for Expected Market Return at 8.5% * Euribor is 2%
* Before tax cost of debt = 5%
* Tax rate = 30%

Please calculate the weighted average cost of capital (WACC) for this firm.

2. You are now asked to calculate the WACC for a toothpaste manufacturer with the following data: * Average share price for last 6 months = €34/ share * Current year’s dividend = €3/ share

* Applicable growth rate = 3%
* Tax rate = 35%
* Company is financed via 75% equity
* Industry average unlevered beta = 1.84
* Company’s debt is in the form of a syndicated loan that carries an interest rate of 4.5% Please calculate the weighted average cost of capital (WACC) for this firm.

3. As an IE Business School graduate, you become the new CFO in the family owned firm. The company is struggling with liquidity, so you know you will need to use your best skills to get debt rolled over. Your elders (the Board) ask you to calculate the cost of equity with the following information:

a. Historically, shareholders have perceived a return of 4% over that of debt holders, to compensate for the added risk. b. Last year, the company was granted a loan at a rate of 6%. Shareholder retribution was 10% c. As of today, the bank grants a loan at7%

d. Share price is currently €40 and next year’s dividend is expected to be €4 per share. e. Expected growth rate is 3%
f. Applicable RFR is 2%
g. Risk Premium stands at 5%
h. Industry average unlevered beta is 1.4
i. % debt in Capital Structure is 30%

4. You are the CFO of New Horizons, a travel agency. You have...

...discounted payback NPV IRR, MIRR
The Cost of Capital
• Cost of Capital Components
– Debt – Common Equity
• WACC
Should we focus on historical (embedded) costs or new (marginal) costs?
The cost of capital is used primarily to make decisions which involve raising and investing new capital. So, we should focus on marginal costs.
What types of long-term capital do organizations use?
nLong-term debt nEquity
Weighted Average Cost of Capital is the weighted Average of the Marginal Costs of the Capital Components employed to acquire a long term asset (make a new real investment in things like Plant and Equipment, R&D, Human Capital, a new Product, a new Process, or a new Marketing Channel
Capital Components
Sources of funding that come from investors.
Accounts payable, accruals, and deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the cost of capital. We adjust for these items when calculating the cash flows of a project, but not when calculating the cost of capital.
WACC Estimates for Some Large U. S. Corporations
Company WACC Intel (INTC) 16.0 Dell Computer (DELL) 12.5 BellSouth (BLS) 10.3 Wal-Mart (WMT) 8.8 Walt Disney (DIS) 8.7 Coca-Cola (KO) 6.9 H.J. Heinz (HNZ) 6.5 Georgia-Pacific (GP) 5.9 wd 2.0% 9.1% 39.8% 33.3% 35.5% 33.8% 74.9% 69.9%
What factors influence a company’s WACC?
• Market conditions, especially interest...

...9 Calculating WACC
Mullineaux Corporation has a target capital structure of 60 percent common stock, 5 percent preferred stock, and a 35 percent debt. Its cost of equity is 12.5 percent, the cost of preferred stock is 5.5 percent, and the cost of debt is 7.2 percent. The relevant tax rate is 35 percent.
a. What is Mullineaux’s WACC?
b. The company president has approached you about Mullineax’s capital structure. He wants to know why the company doesn’t use more preferred stock financing, since its cost less than debt. What would you tell the president?
Weighted average Cost of Capital = E/V * Cost of Equity + D/V * cost of debt * (1-tax rate)
Answer A - Mullineaux's WACCWACC = 60%*14 + 5%*6 + 35%*8*(1-0.35)
WACC = 8.4% + 0.3% + 1.82%
WACC = 10.52%
Answer B
Lets analyse to following situations..
Situation 1 - Equity 50%, Preferred Stock 25% & Debt 25%
WACC = 50%*14 + 25%*6 + 25%*8*(1-0.35)
WACC = 7% + 1.5% + 1.3%
WACC = 9.8%
Situation 2 - Equity 60%, Preferred Stock 20% & Debt 20%
WACC = 60%*14 + 20%*6 + 20%*8*(1-0.35)
WACC = 8.4% + 1.2% + 1.04%
WACC = 10.24%
Situation 3 - Equity 60%, Preferred Stock 35% & Debt 5%
WACC = 60%*14 + 35%*6 + 5%*8*(1-0.35)
WACC = 8.4% + 2.1% + 0.26%...

...1. Why do think Larry Stone wants to estimate the firm’s hurdle rate? Is it justifiable to use the firm’s weighted average cost of capital as the divisional cost of capital? Please explain.
(10% weighting)
Answer
The hurdle rate is the rate of return a firm has to offer finance providers to induce them to buy and hold financial security. (Arnold,2007). This is also known as cost of capital or weighted average cost of capital. The returns offered by alternative securities with the same risk influences the hurdle rate.
Larry Stone would need to estimate the firm’s hurdle rate because the firm would have to earn a minimum rate of return to cover all the costs generated from funds used to finance investment. The firm’s bonds and stocks would not be sold if the firm does not a minimum rate that covers their cost of generating funds.
When there are differences in the degree of risk between the firm and its divisions then it is not justifiable to use the firm’s weighted average cost of capital as the divisional cost of capital.
We use the company's cost of capital to value new assets which have the same risk as the old ones. If the company is acquiring new assets whose risk is more or less than the risk of the existing assets then the capital required to finance(fund) the new assets will have a different cost of capital as investors demand a return based on the risk to their investment....

...What is the WACC and why is it important to estimate a firm’s cost of capital? Do you agree with Joanna Cohen’s WACC calculation? Why or why not?
1.1 The definition of WACC Weighted average cost of capital(WACC), is a weighted-computational method of analyzing the cost of capital based on the whole capital structure of a firm. The result of WACC is the rate a firm use to monitor the application of the current assets because it represents the return the firm MUST get. For example this rate could be used as the discount rate of evaluating an investment, and maintaining the price of firm’s stock.
1.2 Analysis of Johanna Cohen’s calculation We analyzed the process of Johanna Cohen’s calculation, and found some flaws we believe caused computational mistakes.
i. When using the WACC method, the book value of bond is available as the market value since bonds are not quite active in the market, but the book value of equity isn’t. Instead of Johanna’s using equity’s book value, we should multiply the current price of Nike’s stock price by the numbers of shares outstanding.
ii. When calculating the YTM of the firm’s bond, Johanna only used the interest expense of the year divided by the average debt balance, which fully ignored the discounted cash flow of the cost of debt.
2. If you do not agree with Cohen’s analysis, calculate your own WACC for Nike and be prepared...

...WACC- Weighted average cost of capital, annual percentage cost of financing a project of average risk. The WACC is not a reflection of all projects and divisions only for specific projects.
Factors that affect WACC- Market conditions, firm’s capital structure, firm’s investment policy. Riskier policies= Higher WACC
Ways companies can raise common equity- Issue new shares of common stock, reinvest earning that are not paid out as dividends.
CAPM- Rs= Rrf+B(Rm-Rrf); Rrf+B(RPm)
DCF- Rs= D1/Po+G
Project risk= Stand alone risk, Corporate risk, and Market risk.
Steps in capital budgeting- Estimate cash flows, assess risk of cash flows, determine required return, evaluate cash flows.
NPV= CFo + (CF1/(1+r)^1) + (CF2/(1+r)^2) +….
IRR= internal rate of return on a project. MIRR= The % return on a project if the cash flows are reinvested at the cost of capital.
Mutually exclusive= if one project is taken then the other must be rejected.
Normal CF= initial cost of project followed by series of positive CF. Nonnormal CF= CFs of project switch back and forth from positive to negative.
Incremental CF- Sunk costs are irrelevant, Opportunity costs are relevant
Cannibalization- If a new product line were to decrease the sales of the firms other products. (Externality)
Always adjust for inflation when estimating cash flows. Risk in Capital Budgeting means an uncertainty in the projects future returns or CFs....

...The Cost of Capital Project: Internet Version {December 2009}
By
Wm R McDaniel, PhD
Objective
The assignment is to estimate the weighted average cost of capital (WACC) for an actual corporation as of the current time. Actual managers would need to know their company’s WACC 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 WACC in net present value analysis comes later in the course. For now, start with the equations for WACC, per se:
ka = ke(E/V) + kd(1 – t)(B/V) + kp(P/V) + kL(L/V) [1]
V = E + B + P + L [2]
The symbol, ka, is the same as WACC. 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...

...Chapter 12 – Determinants of Beta and WACC
[pic]
Ct is not known for certain. It is a random variable. It has a probability distribution with a mean and standard deviation.
Ct = E(Ct) = expected cash flow
“r” is the appropriate cost of capital. It should have the same riskiness as Ct
If Ct is a normal extension of the firm’s operations, and the firm is entirely equity financed, we use the stockholders’ required return as found through the CAPM for the appropriate value of ‘r’.
E(Ri) = Rf + (i (Rm – Rf)
Remember: the Beta of security i is the standardized covariance of its returns with the returns on the market portfolio.
(i = Covi,Mkt
(2Mkt
Determinants of Beta
1. Cyclicality of revenues – How responsive are revenues to changes in the business cycle?
Does the firm produce normal goods or inferior goods?
Highly cyclical ( high covariance with the market ( high beta.
2. Operating Leverage (Degree of Operating Leverage) – Degree to which costs are fixed.
High FC relative to VC ( high operating leverage
Contribution margin = Price – VC = incremental profit from an additional sale
Low Contribution margin = low FC & high VC = low DOL – example is grocery store
High Contribution margin = high FC & low VC = high DOL – example is airline
High Operating Leverage ( profits are more responsive to changes in sales ( higher beta
3. Financial Leverage – similar to operating leverage if we think of debt as a FC...

...works when WACC does, and sometimes when WACC doesn’t, because it requires fewer restrictive assumptions | Some limitations amount to technicalities, which are much more interesting to academics than to managers. |
| Less Prone to serious errors than WACC. | Income from stocks- as opposed to bonds- may be taxed differently when the investor files a personal tax return : this usually causes an analyst to overestimate the net advantage associated with corporate borrowing when computing the present value of interest tax shields |
| General Managers will find that APV’s power lies in the added managerially relevant information it can provide. | Most analysts neglect costs of financial distress associated with corporate leverage, and they may ignore other interesting financial side effects as well. |
| Flexible – analyst can configure a valuation in whatever way makes most sense for the people involved in managing its separate parts. | APV remains a DCF methodology and is poorly suited to valuating projects that are essentially options. |
| Exceptionally transparent: you get to see all the components of value in the analysis. None are buried. | |
| Based on dollar level of debt and level of debt it known | |
| ADVANTAGES | DISADVANTAGES |
WACC | | |
Approach is to adjust the discount rate (cost of capital) to reflect financial enhancements. | (supposed to handle financial side effect...