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Q: Calculating Weighted Average Cost Of Capital ( Answered ,   0 Comments )
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 Subject: Calculating Weighted Average Cost Of Capital Category: Business and Money > Accounting Asked by: mrjackd-ga List Price: \$25.00 Posted: 11 Aug 2005 09:29 PDT Expires: 10 Sep 2005 09:29 PDT Question ID: 554492
 ```The following question is based on UK financial accounting principles, they do vary slightly from the US, as im sure you know. The board of ?????? plc are considering the manufacture of a new product. The new product would require the company to open a new factory. Cash flow forecasts relating to the project have been compiled, and it is estimated that the initial capital investment required would amount to £5 million. The company's current (30 june 2005) authorised and issued share capital consists of 10 million ordinary shares of 10p each, and this has not changed since May 1998. The market price of the shares at 30 June 2005 is 198p ex div. ??????? plc has pursued a policy of declaring a single dividend each year, payable on the 30 June. Recent dividends have been as follows: YEAR DIVIDEND per share (pence) 2001 5.40 2002 5.53 2003 6.10 2004 6.75 2005 7.35 ?????? plc currently has 1 million 10% debentures redeemable on 30 June 2009, interest being payable each year on 30 June. The current price of the debentures is £85% ex interest. The company has an outstanding bank loan of £1 million repayable on 30 June 2013. The bank loan attracts interest at a variable rate, which is 1% abobe the banks base rate, which is currently 5%. What i need is the following: a) Calculate the weighted average cost of capital (WACC) for ?????? plc as at June 30 2005. b) Bullet point the implicit assumptions if the WACC in (a) above is used to discount the expected cash flow of the proposed new project. c) Bullet point the practicle problems in estimating the WACC for a large UK company with a stock exchange listing. The fist question is the main one, the other two question actually need discussion, but seeing as I am not paying 100 - 200 dollars, i have asked for bullet points only. If however you want to write a descussion then please feel free :).``` Request for Question Clarification by omnivorous-ga on 12 Aug 2005 05:25 PDT ```Mrjackd -- There's at least one factor missing in order to provide an answer to this question: the corporate tax rate for ??????? plc. Taxes reduce the cost of the debt. I know that both U.K. and U.S. researchers have looked at this question (I'm in the U.S.), but I don't believe that the difference between U.S. and U.K. GAAP makes any difference here. The only practical impact might be in depreciation rules between countries -- but those are local tax issues and not GAAP issues. The major issues in treating WACC are common finance issues, perhaps with some foreign exchange issues added if the project being funded is outside the U.K. Best regards, Omnivorous-GA``` Clarification of Question by mrjackd-ga on 12 Aug 2005 05:51 PDT ```As it stands, the information I have been provided for this question is all shown here as it has been given to me. Seeing as there is no mention of tax in the background for the question, I assume it is expected that the calculation is done imagining that tax did not exist.```
 ```Mrjackd ? There are dozens of minor differences in U.S. and U.K. generally-accepted accounting practices or GAAP. The differences are in such things as revenue recognition, treatment of assets, treatment of derivatives but I don?t think any are really relevant to this question, which is about financial theory. As I?m sure you know it?s the Financial Accounting Standards Board (FASB) which governs U.S. GAAP and the International Accounting Standards Board (IASB) which governs U.K. accounting principles: FASB ?FASB Works With IASB Towrd Global Convergence,? (Nov. 27, 2002) www.fasb.org/articles&reports/ fasb&iasb_work_toward_convergence_tfr_nov2002.pdf --- Now that I?m done with that disclaimer, I have to put on another disclaimer ? but this regarding finance standards. For decades there was strong debate on ?cost of equity.? It was important in a variety of ways, including regulated industries, which by law have certain returns allowed. (A friend used to argue these types of cases with state agencies for a telephone company until the mid-1970s.) Finally, by the mid-1970s, the Capital Asset Pricing Model (CAPM), developed by William F. Sharpe in the 1960s, became widely accepted for pricing capital. It predicts that a risk will carry a premium in the prices of bonds or stocks ? and that the stock?s required return is determined by it?s ?beta? or covariance with the expected stock market returns. Sharpe was awarded the Nobel Prize for the work in 1990: NobelPrize.org ?THIS YEAR'S LAUREATES ARE PIONEERS IN THE THEORY OF FINANCIAL ECONOMICS AND CORPORATE FINANCE,? (Oct. 16, 1990) http://nobelprize.org/economics/laureates/1990/press.html The full valuation model, widely used throughout finance is spelled out in this excellent Price Waterhouse page: PricewaterhouseCoopers ?PricewaterhouseCoopers WACC Formula? http://www.pwc.com/Extweb/pwcpublications.nsf/docid/2FC3C1F236E6ED328525694200135FB5 So here?s the disclaimer: we have neither tax rate, nor beta (nor risk-free rate) ? so we have to find another, less generally accepted financial model for valuing the Re or return on equity. That would be a dividend valuation model. Oh, and note that the WACC that we get in the end will be a pre-tax model. That?s not bad for operational measures like comparing various projects internally but would not be accurate for an outside investor looking at the company. --- DIVIDEND VALUATION MODEL The general model for stock pricing looks like this: Pi = Di / (Re-g) Pi = price in period i Di = dividends in period i Re = required rate of return (in decimals) g = dividend growth rate (in decimals) i = period, usually expressed in years From the financial information on 7? Plc we know that: P = 198p D = 7.35 All we have to do is to figure the dividend growth rate to find Re. There are several ways to do it: 2002 growth: 2.41% 2003 growth: 10.31% 2004 growth: 10.66% 2005 growth: 8.99% AVERAGE = 8.09% You can also take the 2001-2005 growth of 36.11%, then calculate a compounded growth rate over 4 years. That?s 8.01% CAGR (compounded average growth rate) = 8.01% At this point, it?s important to remember that your capital cost estimates are just that ? estimates. You?re trying to arrive at a value that represents the MINIMUM return acceptable for internal projects. The company may choose a higher hurdle rate for riskiness or in particular operating areas. The rate may also be changing ? as in the U.S. these days where the chairman of the Federal Reserve is trying hard to push up interest rates. But net, there?s not much difference between 8.01% and 8.09%. I?ll choose the lower number, so: 198p = 7.35p / (Re ? 0.0801) =? Re = 7.35/198 + 0.0801 = .0371 + 0.0801 = 11.72% ---- WACC The weighted-average cost of capital is figured by calculating debt and equity costs at the current market value. From the PricewaterhouseCoopers page: WACC = Rd(1-Tc) * D/V + Re * E/V where: Rd: pre-tax cost of debt, based on the current yield on traded company debt instruments Tc: the marginal corporate tax rate D, E & V: D and E are the market values of the business' debt and equity respectively and V is the sum of D and E. Therefore, D/V and E/V represent the relative weightings of debt and equity Re cost of equity Since we?re doing this as pre-tax, Tc = 0 and things simplify to: WACC = Rd * D/V + Re * E/V D = ?0.85M + ?1M = ?1.85M (8.55%) E = ?19.8M (91.45%) V = ?21.65M The debentures (now valued at only \$850,000) are yielding 11.76% and the bank link of credit 6%. So the mixed debt payments are: Rd = 0.4595 * (11.76%) + 0.5405 * (6%) = 5.40% + 3.24% = 8.64% WACC = 8.64% (0.0855) + 11.72% (0.9145) = 0.7387 + 10.72 = 11.46% --- ASSUMPTIONS IN WACC There are dozens of assumptions behind a WACC calculation but I?ll list the more important ones: ? the project investment is not inherently more (or less) risky than the business in general ? the new product will produce a minimum return of 11.46% in pre-tax net present value (NPV) ? costs of raising capital are not important in taking on the project ? the financing method itself for the project will not have a significant impact on the cost of capital here ? no taxes are being paid. As noted previously at contemporary tax rates, they dramatically reduce the cost of borrowing ? future dividend growth is expected to match that of the past 4 years --- PRACTICAL PROBLEMS FOR LARGE PUBLIC COMPANY ? The company is diversified and each division has a different business risk ? thus a different cost-of-equity and WACC. ? Each division is also likely to have a different optimal debt-equity ratio, yet all divisions share the overhead of the bonded indebtedness. ? Leasing of equipment or property can change the debt-equity structure and not show on the balance sheet. (This is one area where there has been quite a bit of effort to standardize U.S. and U.K. rules by creating a classification of capitalized leases.) ? If the new product investment is to occur outside the U.K. there is additional foreign exchange risk involved in reporting assets, liabilities and earnings. It may require a hedging strategy to reduce currency translation risks. You may wish to explore other risk factors. The following Google search strategies work pretty well at bringing up a mix of academic and practical articles: Investments ?issues with? WACC ?Investment risk? ?cost of capital? Google search strategy: ?differences between? IASB FASB WACC + ?cost of equity? Investments ?issues with? WACC Best regards, Omnivorous-GA```