Purpose Of Assignment Students Should Understand The 110279

Purpose Of Assignmentstudents Should Understand The Mechanics In Calcu

Purpose of Assignment 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. Scenario: You work for an investment banking firm and have been asked by management of Vestor Corporation (not real), a software development company, to calculate its weighted average cost of capital, to use in evaluating a new company investment. The firm is considering a new investment in a warehousing facility, which it believes will generate an internal rate of return of 11.5%. The market value of Vestor's capital structure is as follows: Source of Capital Market Value Bonds $10,000,000 Preferred Stock $2,000,000 Common Stock $8,000,000 To finance the investment, Vestor has issued 20 year bonds with a $1,000 par value, 6% coupon rate and at a market price of $950. Preferred stock paying a $2.50 annual dividend was sold for $25 per share. Common stock of Vestor is currently selling for $50 per share and has a Beta of 1.2. The firm's tax rate is 34%. The expected market return of the S&P 500 is 13% and the 10-Year Treasury note is currently yields 3.5%. The discount rate Vestor should use to evaluate the warehousing project is 9.18%. Assess whether Vestor should make the warehouse investment. Prepare the analysis of the project and the decision to be made (approx. 400 words). Format your assignment consistent with APA guidelines. As always make sure you provide references and let us know where you are using them. Also see attachment with Instructor Notes.

Paper For Above instruction

The process of evaluating investment opportunities within a corporate finance context requires understanding the company's cost of capital, particularly the weighted average cost of capital (WACC), which incorporates the costs of debt, preferred equity, and common equity. Accurate calculation of WACC is essential in determining whether a new project will generate returns exceeding its cost, thereby creating value for shareholders. This paper examines the calculation of Vestor Corporation’s WACC using the Capital Asset Pricing Model (CAPM) and assesses whether the firm should proceed with constructing a new warehousing facility, considering an estimated internal rate of return (IRR) of 11.5%.

Calculating the Cost of Debt

The first step involves determining the after-tax cost of Vestor’s debt. The company has issued bonds with a face value of $1,000, a coupon rate of 6%, and a market price of $950. The annual coupon payment is calculated as:

Coupon payment = $1,000 x 6% = $60

The yield to maturity (YTM), which approximates the cost of debt, can be computed considering the bond's current price, coupon payments, and maturity. Using a financial calculator or YTM formula, the approximate YTM here is about 6.41%. To represent the after-tax cost of debt:

Cost of debt (after-tax) = YTM x (1 - Tax rate) = 6.41% x (1 - 0.34) ≈ 4.23%

Calculating the Cost of Preferred Stock

The preferred stock pays an annual dividend of $2.50 and sells for $25 per share. Its cost is determined by dividing the dividend by the net issuing price:

Cost of preferred stock = $2.50 / $25 = 10%

Calculating the Cost of Equity Using CAPM

The CAPM states that:

Cost of equity = Risk-free rate + Beta x (Market return - Risk-free rate)

Given the data: risk-free rate = 3.5%, beta = 1.2, market return = 13%, the cost of equity is:

Cost of equity = 3.5% + 1.2 x (13% - 3.5%) = 3.5% + 1.2 x 9.5% = 3.5% + 11.4% = 14.9%

Calculating the Weighted Average Cost of Capital (WACC)

The market values of the sources of capital are: bonds ($10 million), preferred stock ($2 million), and common stock ($8 million). The total market value equals $20 million. The proportion of each component is as follows:

• Debt: $10 million / $20 million = 50%
• Preferred stock: $2 million / $20 million = 10%
• Equity: $8 million / $20 million = 40%

Thus, the WACC formula is:

WACC = (E/V) x Re + (P/V) x Rp + (D/V) x Rd x (1 - Tax rate)

Where:

• Re = 14.9% (cost of equity)
• Rp = 10% (cost of preferred stock)
• Rd = 4.23% (after-tax cost of debt)
• Tax rate = 34%

Calculating WACC:

WACC = 0.40 x 14.9% + 0.10 x 10% + 0.50 x 4.23% = 5.96% + 1% + 2.115% = 9.075%

In practice, the company has adopted a discount rate of 9.18%, which aligns closely with this calculated WACC.

Investment Decision

The estimated internal rate of return (IRR) for the new warehousing project is 11.5%. Since the project’s IRR exceeds the WACC of approximately 9.18%, the project is expected to generate excess returns above the company's cost of capital, thus creating value for shareholders. According to financial theory, investments with IRRs exceeding their WACC are generally considered good projects (Damodaran, 2012). Therefore, Vestor should proceed with the warehouse investment as it meets the criteria for value addition.

Conclusion

Calculating the WACC using CAPM and other sources of capital is fundamental for assessing investment viability. The analysis demonstrates that Vestor’s IRR exceeds its cost of capital, supporting the decision to invest in the warehousing facility. This decision aligns with sound financial principles aimed at maximizing shareholder value.

References

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