3.11 Estimation of Cost of Debt (Investopedia, n.d.) Cost of Debt is the rate of return that a company is obliged to give to its bondholders. In order to calculate the cost of debt, firstly, we have taken the interest expense for all the years from the Profit and Loss statement (available in annual report) of their respective companies. Then we divide the interest expense of a company with their total debt, which we have estimated in above methodology. This will give us the cost of debt of a company. Same procedure is repeated for all the companies for all the 9 years. 3.12 Estimation of WACC of Individual Companies (Accountingexplained, n.d.) WACC is the overall cost of capital in order to raise capital from the company’s perspective, which …show more content…
Therefore, by substituting the respective values in the above formula we can estimate the cost of equity of respective companies for all the 9 years. 3.13 Estimation of WACC of an Index WACC of an index is estimated by assigning weight to each of the individual companies. WACC based on the market capitalization over index market capitalization. The Formula, which we have used to calculate the WACC of an index, is mentioned below: We have already estimated Market Capitalization of all 50 securities, their individual WACC and total Market Cap of an index using above methodology. Therefore, by substituting the respective values in the above formula we can estimate the WACC of an Index for all the 9 years. 3.14 Estimation of Cost of Equity (CoE) of an Index CoE of an index is estimated by assigning weight to each of the individual companies cost of equity based on their market capitalization over index market capitalization. The Formula, which we have used to calculate the CoE of an index, is mentioned …show more content…
The immediacy of the WACC (red line) to the CoE (green line) shows companies prefer equity financing over debt even if it is an expensive source of capital, and take good amount of time to raise the money. From the chart, it is visible that, CoE is higher up to 17.21% in year 2005 and dipped to 16.22% in 2013. This variation of CoE during last 10 years period was about 1%. However, CoD was 4.56% in 2005 and peaked to 8.67% in 2013. The variation of CoD during this period was about 4.1%. This enormous disparity shows the instability of interest rates in India over the last one decade. One of the reasons of this disparity is the continuous effort of Reserve Bank of India to control inflation by taking various steps under monetary
Net working capital represents organization’s operating liquidity. In order to compute the net working capital, total current assets are divided from total current liabilities. When there is sufficient excess of current assets over current liabilities, an organization might be considered sufficiently liquid. Another ratio that helps in assessing the operating liquidity of as company is a current ratio. The ratio is calculated by dividing the total current assets over total current liabilities. When the current ratio is high, the organization has enough of current assets to pay for the liabilities. Yet, another mean of calculating the organization’s debt-paying ability is the debt ratio. To calculate the ratio, total liabilities are divided by total assets. The computation gives information on what proportion of organization’s assets is financed by a debt, and what is the entity’s ability to pay for current and long term liabilities. Lower debt ratio is better, because the low liabilities require low debt payments. To be able to lend money, an organization’s current ratio has to fall above a certain level, also the debt ratio cannot rise above a certain threshold. Otherwise, the entity will not be able to lend money or will have to pay high penalties. The following steps can be undertaken by a company to keep the debt ratio within normal
The WACC is basically computed by the sum of multiplying the costs per component to its respective proportional weight (how much that company uses a certain cost of capital) [See Appendix 1]. As financial management is focused on the maximization of the stock price, an optimal structure of costs based on these three factors is needed.
In order to do this the WACC approach will be used based on the assumption that leverage will stay constant after 2012. Industry average of debt/value is 28.1 percent and debt/equity 71.9 percent. These figures will be used as an estimate for long-term leverage because it is expected that AirThread will maintain a leverage ratio that is constant with the industry. From this the relevered equity beta is found to be 0.9847 which will give an equity rate of return of 9.42 percent. The rate of return on debt will be 5.5 percent. This is the percentage of debt because it is the interest rate of the 10 year U.S. Treasury bond. The WACC is now found to be 7.80 percent. Next, the long-term growth rate of 2.9 percent will be assumed to stay constant. In order to determine the FCF 2013 FCF 2012 of $315.60 will be multiplied by the growth rate. This will give a FCF 2013 of $323.48. The FCF 2013 will then be divided by the WACC minus growth rate. By doing this the PV of terminal value is found to be approximately $4.6 billion. To see the calculations for this step refer to Exhibit 3 in the
Star Appliance is looking to expand their product line and is considering three different projects: dishwashers, garbage disposals, and trash compactors. We want to determine which project would be worth doing by determining if they will add value to Star. Thus, the project(s) that will add the most value to Star Appliance will be worth pursuing. The current hurdle rate of 10% should be re-evaluated by finding the weighted average cost of capital (WACC). Then by forecasting the cash flows of each project and discounting them by the WACC to find the net present value, or by solving for the internal rate of return, we should be able to see which projects Star should undertake.
Equity capital represents money put up and owned by shareholders. This money can be used to fund projects and other opportunities under the auspice of creating greater value. This type of capital is typically the most expensive. In order to attract investors, the firms expected returns must consummate with the associated risk ("Financial leverage and,"). To illustrate this, consider a speculative oil drilling operation, this type of operation would require higher promised returns than say a Wal-Mart in order to attract investors. The two primary forms of equity capital are 1) money invested into the business for an ownership stake (i.e. stock) and 2) retained earnings from past profits used to fund future growth through acquisitions, expansions and product development.
First of all an analysis of the packaging machine investment’s hurdle rate is required. I will use comparable firm parameters approach to figure out the hurdle rate (WACC) of the firm using the information provided in Exhibit 5. The cost of debt should be calculated using the bond information given in footnote 2 of case under Exhibit 2. The cost of equity should be calculated using the Capital Asset Pricing Model.
If we look at the sensitivity analysis, we find as WACC increases, the percentage of US$360M investment in Deltex also increases. When WACC is 5.8%, the percentage of US$360M investment in Deltex is equal to 30% equity of Deltex.
The second method we used to analyze the firm’s value was the Comparable Companies Method. We used the historical figures as of 1990 and Goldmans Sach’s Projections. With an average of 22.
WACC is the weighted average return on capital that includes both cost of debt and equity, whereby we discount total cash flows by the appropriate discount rates
(CAPM). Other methods, such as the dividend-discount model (DDM) and the earnings-capitalization ratio, can be used to estimate the cost of equity. In my opinion, however, the CAPM is the superior method.
...ccurately reflects the intrinsic value of the company from the shareholders point of view and their expectations of future earnings.
a. 1. What sources of capital should be included when you estimate Harry Davis’s weighted average cost of capital (WACC)?
Capital Asset Pricing Model (CAPM) is an ex ante concept, which is built on the portfolio theory established by Markowitz (Bhatnagar and Ramlogan 2012). It enhances the understanding of elements of asset prices, specifically the linear relationship between risk and expected return (Perold 2004). The direct correlation between risk and return is well defined by the security market line (SML), where market risk of an asset is associated with the return and risk of the market along with the risk free rate to estimate expected return on an asset (Watson and Head 1998 cited in Laubscher 2002).