Defining Capital Structure Weights - Templeton Extended Care

Defining Capital Structure Weights Templeton Extended Care Facilitie

Templeton Extended Care Facilities, Inc is considering the acquisition of a chain of cemeteries for $430 million. Since the primary asset of this business is real estate, Templeton's management has determined that they will be able to borrow the majority of the money needed to buy the business. The current owners have no debt financing but Templeton plans to borrow $330 million and invest only $100 million in equity in the acquisition. What weights should Templeton use in computing the WACC for this acquisition? The appropriate wd weight is % (Round to one decimal). The appropriate wcs weight is % (Round to one decimal place).

Paper For Above instruction

Weighted Average Cost of Capital (WACC) is a crucial financial metric used to evaluate the average rate of return that a company is expected to pay to finance its assets through a combination of debt and equity. Correctly determining the weights of debt (wd) and equity (we) in the WACC formula is essential because these weights directly influence the overall cost of capital, impacting investment decisions and valuation analyses. In the case of Templeton Extended Care Facilities’ potential acquisition, understanding how to accurately assign these weights based on the proposed financing structure is fundamental to an accurate financial assessment.

In this scenario, Templeton plans to finance the $430 million acquisition primarily through debt, borrowing $330 million while investing $100 million in equity. The total acquisition cost will thus be financed by these two sources, leading us to compute the appropriate weights for debt and equity based on these values. The fundamental principle in calculating these weights is to reflect the proportion of each financing component in the total capital structure.

The debt weight (wd) is calculated as the proportion of total capital funded by debt:

\[

wd = \frac{\text{Debt}}{\text{Total Capital}} = \frac{330\, \text{million}}{430\, \text{million}}

\]

which simplifies to approximately:

\[

wd = \frac{330}{430} \approx 0.7674 \text{ or } 76.7\%

\]

Similarly, the equity weight (we) is computed as:

\[

we = \frac{\text{Equity}}{\text{Total Capital}} = \frac{100\, \text{million}}{430\, \text{million}}

\]

which approximates to:

\[

we = \frac{100}{430} \approx 0.2326 \text{ or } 23.3\%

\]

Therefore, based on Templeton's financing plan for this acquisition, the debt weight (wd) should be approximately 76.7%, and the equity weight (we) should be approximately 23.3%. These weights should be rounded to one decimal place as per the instructions:

  • wd = 76.7%
  • we = 23.3%

Accurately determining these weights ensures that the WACC calculation reflects the true risk and return profile of the financed assets, aiding management in making informed investment decisions. It is also important to note that these weights can fluctuate based on variances in the actual debt or equity used for financing, and it is essential for companies to regularly revisit these calculations to maintain an accurate assessment of their cost of capital.

Moreover, in real-world scenarios, additional adjustments might be necessary to account for factors such as the cost of debt, the after-tax cost of debt (considering interest tax shields), and the risk profile associated with the particular assets or industry. Nonetheless, the fundamental calculation presented here lays the groundwork for precise financial analysis and prudent capital structure management.

References

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