Cost of capital refers to the cost of obtaining funds, that is, debt or equity to finance an investment project. The cost of capital is useful in assessing the applicability of a capital account because the cost of capital is the lowest return for the investor to fund the company. Different sources of capital have different capital costs. On the other hand, risk refers to the uncertainty that exists in making financial decisions. Because the forecast may be different from the actual result, for example, the stock price may change unfavorably. The risk can be divided into two categories: systemic risk and non-systemic risk. The risk is measured by variance analysis or beta. (Brigham & Ehrhardt, 2011).
Weighted Average Cost of Capital (WACC)
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Here uses Capital Asset Pricing Model (CAPM) to calculate the required rate of return. The formula is:
Cost of Equity = Risk-Free Rate of Return + Beta of Asset * (Expected Return of the Market - Risk-Free Rate of Return)
a) Here uses 10-Year Treasury Constant Maturity Rate as the risk-free rate. It is updated daily. The current risk-free rate is 2.78000000% (apple, 2017).
b) Beta is the sensitivity of the expected excess asset returns to the expected excess market returns. Apple Inc's beta is 1.08 (AAPL, 2017).
c) (Expected Return of the Market - Risk-Free Rate of Return) is also called market premium. Here requires market premium to be 6% (AAPL, 2017).
Cost of Equity = 2.78000000% + 1.08 * 6% = 9.26%
3. Cost of Debt:
Here uses last fiscal year end Interest Expense divided by the latest two-year average debt to get the simplified cost of debt.
As of Sep. 2017, Apple Inc's interest expense (positive number) was $2323 Million. Its total Book Value of Debt (D) is $101356 Mil (Gurufocus,
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The latest Two-year Average Tax Rate is 25.06% (Gurufocus, 2017).
Apple Inc.’s Weighted Average Cost Of Capital (WACC) for Today is calculated as:
WACC = E / (E + D) * Cost of Equity + D / (E + D) * Cost of Debt * (1 - Tax Rate)
= 0.8936 * 9.26% + 0.1064 * 2.2919% * (1 - 25.06%)
= 8.46%
A WACC of 8.46 % means that the average cost of capital when both equity and debt is used is 8.46%. This WACC can be used as a discounting factor for capital projects (Gurufocus, 2017).
The security market line is a graphical representation of the CAPM model that shows the expected return on security as a systemic, non-decentralized risk function. All properly priced assets will be located in the securities market. The y-axis intercept of the safe market line will represent a risk-free interest rate and the slope is a risk premium. Any security measures on this line are either overpriced or underpriced, and these are effective / reasonable pricing.
Summary and
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.
Based on the Consolidated Statements of Shareholder?s Equity, year ended September 2015, in page 71, as shown in the statement, there are no preferred stocks.
The estimates of cost of capital for equity 6.14% are making by using the capital asset pricing model (CAPM) to generate forecast of DDM and RIM. This method is defined by the sum of risk free rate plus beta that multiplied with a risk premium. Particularly, the beta, which is a quantitative measure of the volatility of company stock relative to the unstable of the overall market, found in JB HI-FI case at 0.56 (JB HI-FI financial statement 2016). It
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 investors’ risk aversion increased so that the market risk premium rose from 7% to 8%, TECO’s required rate of return would increase = 8% + (8%)0.6 = 8% + 4.8% = 12.8% If TECO’s beta rose from 0.6 to 1, TECO’s required rate of return would increase = 8% + (15% - 8%)1 = 8% + 7% = 15% 10. According to the EMH stocks are always in equilibrium. Investors can never beat the market. Additionally, according to the EMH concept, the expected return of a stock would be the required return of such stock. The concept does not consider plant property and equipment.
The many factors affecting WACC are: general economic conditions, market conditions, the firm's operating and financial decisions, amount of financing, business risk, constant financial risk, and dividend policy. These factors have a direct impact on the variables used in calculating WACC. Such variables include the term structure of interest rate, the risk free rate, the beta, the market risk premium, the firm's marginal tax rate, and its capital structure.
Smart beta ETFs are ETFs built for outperformance that track a rule-based index. They are transparent in that they provide exposure to a specific risk factors other than market cap weighted size, growth, value, or industry sectors. Also, they are low cost and offer the best benefits of active and passive investing.
Apple’s debt to equity ratio is not very high compared to the industry average of 2.23. The Debt to Equity Ratio of 2014 is 1.08, in which the normal ratio should be less than 1. This ratio of 1.08 shows that the company is financing more assets with debt than equity. In spite
Inputting all my assumptions into the WACC formula, my estimate of Nike's cost of capital is 8.4%.
During the last few years, Harry Davis Industries has been too constrained by the high cost of capital to make many capital investments. Recently, though, capital costs have been declining, and the company has decided to look seriously at a major expansion program that had been proposed by the marketing department. Assume that you are an assistant to Leigh Jones, the financial vice president. Your first task is to estimate Harry Davis’s cost of capital. Jones has provided you with the following data, which she believes may be relevant to your task.
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).
1) the expected cost of the initial base costs for the acquisition of fixed assets that will be used in the project (buildings, facilities, equipment)
The Modern portfolio theory {MPT}, "proposes how rational investors will use diversification to optimize their portfolios, and how an asset should be priced given its risk relative to the market as a whole. The basic concepts of the theory are the efficient frontier, Capital Asset Pricing Model and beta coefficient, the Capital Market Line and the Securities Market Line. MPT models the return of an asset as a random variable and a portfolio as a weighted combination of assets; the return of a portfolio is thus also a random variable and consequently has an expected value and a variance.