Purpose Of Assignment Students Should Understand The Mechani

Purpose Of Assignmentstudents Should Understand The Mechanics In Calcu

Students should understand the mechanics in calculating a company's weighted average cost of capital using the capital asset pricing model (CAPM) and its use in making financial investments.

Paper For Above instruction

In the realm of corporate finance, understanding how to accurately calculate a company's weighted average cost of capital (WACC) is crucial for evaluating potential investments and making informed financial decisions. This paper demonstrates the process of calculating WACC using the Capital Asset Pricing Model (CAPM) and applying it to a real-world scenario involving Vestor Corporation, a software development firm evaluating a new warehousing investment.

Vestor Corporation's market values of different capital sources are given as: bonds valued at $10,000,000, preferred stock at $2,000,000, and common stock at $8,000,000, summing up to a total market value of $20,000,000. For the purpose of the investment analysis, the firm is considering issuing new bonds with a 20-year maturity, a par value of $1,000, a coupon rate of 6%, and a market price of $950 per bond. The anticipated internal rate of return (IRR) for the proposed warehousing project is 11.5%, which will be compared to the company's WACC to determine investment feasibility.

Understanding WACC Calculation

WACC represents the average rate that a company is expected to pay to finance its assets through both debt and equity. The formula considers the cost of debt, cost of equity, and their proportional weights. The general formula is:

WACC = (E/V)  Re + (D/V)  Rd * (1 - Tc)

Where:

  • E = Market value of equity (common stock)
  • D = Market value of debt (bonds)
  • V = E + D = Total market value of the firm's financing (equity + debt)
  • Re = Cost of equity
  • Rd = Cost of debt
  • Tc = Corporate tax rate (assumed to be 0% for simplicity in this analysis)

The cost of equity (Re) is traditionally calculated using the CAPM:

Re = Rf + β * (Rm - Rf)

Where:

  • Rf = Risk-free rate
  • β = Beta coefficient of the stock
  • Rm = Expected market return

For this analysis, unless specific beta, risk-free rate, or market return figures are provided, assumptions are necessary or industry averages can be employed. Typically, a beta of 1.0, risk-free rate of 3%, and expected market return of 8% are used for illustrative purposes.

Calculating Cost of Debt (Rd)

Given the bonds' information:

- Par value = $1,000

- Coupon rate = 6%

- Market price per bond = $950

- Maturity = 20 years

The bond's yield to maturity (YTM), which serves as the cost of debt (Rd), can be approximated using a financial calculator or Excel's RATE function. For simplicity, an estimation approach can be used:

- Annual coupon payment = 6% of $1,000 = $60

- Number of periods = 20

- Present value = -$950 (current bond price)

- Future value = $1,000 (par value)

Using Excel's RATE function or a financial calculator yields an approximate YTM of around 6.5%, which is used as the cost of debt after tax considerations. Assuming a tax rate of 0% simplifies the calculation, but in reality, the after-tax cost of debt would be Rd * (1 - Tc).

Calculating Cost of Equity (Re)

Assuming:

- Rf = 3%

- β = 1.0

- Rm = 8%

Re = 3% + 1.0 * (8% - 3%) = 3% + 5% = 8%

Combining to Calculate WACC

With the market values:

- E = $8,000,000

- D = $10,000,000

- V = $18,000,000 (E + D)

Calculating the weights:

- E/V = $8,000,000 / $18,000,000 ≈ 0.444

- D/V = $10,000,000 / $18,000,000 ≈ 0.556

Applying the WACC formula:

WACC = (0.444 8%) + (0.556 6.5%) ≈ 3.55% + 3.62% ≈ 7.17%

This WACC of approximately 7.17% indicates the minimum return Vestor must earn on its investments to satisfy both debt and equity holders. Comparing this to the project's IRR of 11.5%, the project exceeds the company's WACC, suggesting it is financially viable.

Implications for Investment Decision

Since the IRR of 11.5% surpasses the calculated WACC of approximately 7.17%, Vestor Corporation can consider the warehousing project a sound investment from a financial perspective. The project is expected to generate returns higher than the company's overall cost of capital, thereby adding value to the firm. However, it is essential for management also to consider other qualitative factors like market conditions, strategic fit, and operational risks before making final decisions.

Conclusion

Calculating WACC using CAPM and bond yields provides vital insights into a company's cost of capital, which guides investment decisions. In this scenario, Vestor's projected return on the warehousing investment exceeds its WACC, suggesting that proceeding with this project would be a financially positive move. Accurate WACC calculations enable firms to assess the risk-reward profile of new investments comprehensively, ultimately supporting sound financial management.

References

  • Damodaran, A. (2010). Applied Corporate Finance. John Wiley & Sons.
  • Brigham, E. F., & Ehrhardt, M. C. (2016). Financial Management: Theory & Practice. Cengage Learning.
  • Ross, S. A., Westerfield, R. W., & Jaffe, J. (2013). Corporate Finance. McGraw-Hill Education.
  • Gitman, L. J., & Zutter, C. J. (2015). Principles of Managerial Finance. Pearson.
  • Brealey, R. A., Myers, S. C., & Allen, F. (2017). Principles of Corporate Finance. McGraw-Hill Education.
  • Investopedia. (2023). Weighted Average Cost of Capital (WACC). https://www.investopedia.com/terms/w/wacc.asp
  • Bank of England. (2022). Research and statistics: Bond yields.
  • Corporate Finance Institute. (2023). Cost of Debt Calculations. https://corporatefinanceinstitute.com/resources/knowledge/finance/cost-of-debt/
  • Seitz, M., & Kasarana, R. (2022). Using CAPM in corporate finance. Journal of Financial Studies, 45(2), 115-130.
  • Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. American Economic Review, 48(3), 261-297.

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