X. Weighted average cost of capital (WACC)
The valuation of Abercrombie & Fitch Co. is based discounting future cash flows and economic profit, for that the weighted average cost of capital is needed. The WACC is the opportunity cost when investing in Abercrombie & Fitch Co. opposed to other investments with a similar risk. Investors want their return to excess the WACC before it can be considered a good investment; since people in general are risk averse, they want compensation for taking on risk. In its most simple form the weighted average cost of capital looks as the following equation (Koller p. 232, 2010): Equation X – 1
D/V = target level of debt to enterprise value using market-based values E/V = target level of equity to enterprise value using market-based values kd = cost of debt
ke = cost of equity
Tm = company’s marginal income tax rate
As the equation shows the factors which affects the WACC is the capital structure of the company, the cost of debt with the impact of tax, and the cost of capital. In rest of this section there will be steps, each estimating the different variables. Keep in mind that estimation is not a single correct answer, but using respected models as estimators will give a good unbiased suggestion with the goal of minimizing errors.
X.1 Estimating current capital structure
To estimate the WACC the capital structure is needed. To determine the current capital structure it is important that market-based value is used, and not the book value. Some companies trade their debt public, if so the market value of the debt can be determined by using the TRACE pricing database and it would be the ideal method to use. Since in most cases book value reasonably approximates the current market value it will be observed in the Abercrombie & Fitch Co. Annual report and used to determine the capital structure (Koller p. 263, 2010). To estimate the market value of the company, the number of outstanding shares is multiplied with the stock price at a given time Shares issued and repurchased by the company is not included in the calculation. The Outstanding shares it observed in the annual reports and the historical stock prices is found on the web (http://moneycentral.msn.com). Table X- 1
Source: Own calculation based on information from annual reports fiscals 2006-2010. Table x -1 shows the Debt-to-value ratio and the Equity-to-value over the past five years and in the end the average. Three first three years states a very stable ratio, but in a mixture of more debt and an extreme decrease in the stock price do to the financial crisis, the ratio completely shifted. 2010 indicates that the ratio is moving towards the old target ratio. The average D/V over the five year period is 27,9%, it might seem unreasonable to use this ratio in the estimation of the WACC do to the fact that 3 out five years the D/V ratio was under 14%, but since according to Hirt and Block a business cycle is usually lasting around five years it would academically be the most correct thing to do (Hirt and Block p. 109, 2008). X.2 Tax
The tax rate that will be used to estimate the WACC is 34,3 percent, which is the latest effective tax rate from the fiscal 2010 annual report. The statutory federal income tax rate in the United State is 35%, not far from the effective tax rate of 34,3% elected for further use. The effective tax rate has over last five years has been both higher and lower than the chosen one, but since it is effected foreign earnings, it would be most reasonable to chose the most current effective tax rate.
X. 3 Estimating the cost of equity
Estimating the cost of equity is a very hard task, given that there is no perfect way to do it and no model has gained universal acceptance. The cost of equity is...
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