Weekly Tasks Or Assignments, Individual Or Group Proj 304688

Weekly Tasks Or Assignments Individual Or Group Projects Will Be Due

Weekly tasks or assignments (Individual or Group Projects) will be due by Monday, and late submissions will be assigned a late penalty in accordance with the late penalty policy found in the syllabus. NOTE: All submission posting times are based on midnight Central Time. Your next assignment as a financial management intern is to apply the knowledge that you acquired while engaging in the cost of capital discussion that you had with your colleagues. In this task, you will be calculating the weighted cost of capital for a firm using the book value of the components and the concepts presented in this phase. Using the most current annual financial statements from the company you analyzed in Phase 1, determine the percentage of the firm's assets that are currently being financed with debt (total liabilities), preferred stock, and common stock (common equity).

It is very possible that your firm will have very little or no preferred stock, so in this class, the percent would be "zero." Your ratios should add up to 100%. You will also need to calculate the firm’s average tax rate using the income tax expense divided by the firm's income before taxes. Use the following tables: Company Total Assets Total Liabilities Total Preferred Stock Total Common Equity Dollar Value % of Assets Company Income before Tax Income Tax Expense Average Tax Rate (%) The first component to determine is the cost of debt. Your mentor suggests using the Web site that you used in the previous Phase to find the pretax yield-to-maturity of a bond with at least 5 years left before maturity.

Using the following table, calculate the firm's after-tax cost of debt: Yield to Maturity 1 - Average Tax Rate After-tax Cost of Debt Now you will need to calculate the cost of preferred stock. You can use the following table: Annual Dividend Current Value of Preferred Stock Cost of Preferred Stock (%) To calculate the cost of common equity, you can use the CAPM model. Using current stock data, the yield on the 5-year treasury bond, and the return on the market calculated in Phase 2, you can calculate the cost of common equity using the following table: 5-year Treasury Bond Yield (risk-free rate) Stock's Beta Return on the Top 500 Stocks (market return) Cost of Common Equity Now, you can use the cost and ratios from above to calculate the firm's weighted average cost of capital (WACC) using the following table: After-Tax Cost of Debt Cost of Preferred Stock Cost of Common Equity WACC Unweighted Cost Weight of Component Weighted Cost of Component

After completing the required calculations, explain your results in a Word document, and attach the spreadsheet showing your work. Be sure to explain the following: How would you expect the weighted average cost of capital (WACC) to differ if you had used market values of equity rather than the book value of equity, and why? What would you expect would happen to the cost of equity if you had to raise it by selling new equity, and why? If the after-tax cost of debt is always less expensive than equity, why don't firms use more debt and less equity? What are some of the advantages and disadvantages of raising capital by using debt? How would "floatation costs" impact the WACC, and how could they have been incorporated in the formula? Note: You can find information about the top 500 stocks at this Web site.

Paper For Above instruction

Introduction

The weighted average cost of capital (WACC) is a crucial measure for firms to determine the average rate of return required by all investors, considering the specific capital structure. It integrates the costs of debt, preferred stock, and equity, weighted by their respective proportions in the firm's total capital. Accurate calculation of WACC informs financial decision-making, investment appraisal, and valuation processes, making it a vital component in corporate finance. This paper explores the methodology for calculating WACC using book values, discusses the implications of substituting market values, and examines how capital raising strategies influence the cost of equity and the overall WACC.

Calculating the Capital Components

The first step involves analyzing the firm’s most recent financial statements obtained from Phase 1 to extract the total assets, liabilities, preferred stock, and equity. Computing the proportions (percentages) of each component relative to total assets provides the basis for weighting in the WACC formula. Typically, firms may have minimal or no preferred stock; in such cases, the percentage is zero. The sum of the proportions must equal 100%, aligning with the standard approach in capital structure analysis.

Estimating the Cost of Debt

The cost of debt is conventionally derived from the pretax yield-to-maturity (YTM) of a long-term bond with at least five years remaining until maturity, ensuring the rate reflects the firm’s current borrowing conditions. Using financial data from credible sources or the company’s debt disclosures, the pretax YTM is identified. The firm’s average tax rate, calculated as income tax expense divided by income before taxes, influences the after-tax cost of debt, since interest expenses are tax-deductible. The formula applied is:

After-tax Cost of Debt = Pretax YTM * (1 - Average Tax Rate)

This measure signifies the effective cost to the firm of debt financing after considering tax shields.

Calculating the Cost of Preferred Stock

The preferred stock’s cost is determined by dividing the annual preferred dividend by the current market value per share:

Cost of Preferred Stock = Annual Dividend / Current Market Value of Preferred Stock

This percentage indicates the yield required by preferred stock investors, reflecting the firm’s obligation to pay fixed dividends.

Estimating the Cost of Common Equity Using CAPM

The Capital Asset Pricing Model (CAPM) provides a systematic approach to estimate the cost of equity, incorporating risk-free rates, market risk premiums, and the stock’s specific beta:

Cost of Common Equity = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate)

Here, the risk-free rate typically corresponds to the yield on a 5-year Treasury bond, beta measures the stock’s volatility relative to the market, and the market return is derived from the prior phase analysis of the top 500 stocks.

Calculating the WACC

Having obtained the individual component costs and their respective weights, the overall WACC is computed as:

WACC = (E/V) Cost of Equity + (D/V) Cost of Debt (1 - Tax Rate) + (P/V) Cost of Preferred Stock

Where:

  • E = Market value of equity
  • D = Market value of debt
  • P = Market value of preferred stock
  • V = E + D + P = Total market value of the firm’s capital

The weights are based on market values, but in this context, we are instructed to use book values.

Implications of Using Book vs. Market Values

Substituting market values of equity instead of book values could significantly alter the WACC. Market values reflect current investor sentiment and future growth expectations, often diverging from the book value derived from historical costs. Using market values generally results in a more accurate picture of the firm’s current capital cost structure, which can lead to variations in WACC. For instance, if a company’s equity market value exceeds its book value due to optimistic growth prospects, the calculated WACC might decrease, implying a lower cost of capital and potentially improving valuation metrics.

Impact of Raising New Equity on Cost of Equity

If the firm issues new equity, the cost of equity typically increases because new shares are often issued at a discount to current market prices to compensate investors for dilution and issuance costs. This phenomenon is called the "issue cost" effect, which increases the effective rate of return required by new investors, thereby raising the firm's overall cost of equity. Additionally, issuing new shares can signal management's confidence or concern about the firm's valuation, influencing investor perceptions further.

Thanks to the tax deductibility of interest, debt financing is cheaper than equity; nevertheless, firms do not lean solely on debt due to several risks. Excessive leverage increases financial risk, potentially leading to insolvency during downturns, and may raise the firm’s cost of debt as lenders perceive higher risk. Moreover, debt covenants and the risk of default limit the extent of debt funding. Equity, while more expensive, provides a buffer against financial distress, facilitating stable capital structure management.

Advantages and Disadvantages of Debt Financing

Debt offers advantages such as tax shield benefits, predictable payments, and no dilution of ownership. However, disadvantages include increased bankruptcy risk, the obligation to make interest payments regardless of profitability, and potential constraints from debt covenants. These factors create a delicate balance that firms must navigate when structuring capital.

Impact of Flotation Costs on WACC

Flotation costs are expenses incurred during capital raising, including underwriting, registration, and legal fees. These costs effectively increase the cost of new capital, thus elevating the WACC when new financing is needed. To incorporate flotation costs, the cost of new capital can be adjusted by dividing the initial cost by (1 - flotation cost percentage), which accounts for expenses, thereby providing a more accurate measure for decision-making.

Conclusion

Calculating the WACC using book values provides a snapshot of the firm’s capital costs based on historical data, but employing market values offers a more current reflection of investor expectations and risks. The decision to raise capital with debt or equity involves trade-offs between cost, risk, and financial flexibility. Understanding these dynamics enables better strategic financial planning, ensuring the firm can optimize its capital structure to maximize value while managing risks effectively.

References

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