Scenario Steps to Completion
1. Calculate the company's weighted average cost of capital (WACC) under the following assumptions provided by Sue.
The company's long-term bonds currently offer a yield to maturity of 8 percent.
The company's stock price is $50 per share (P0 = $50).
The company recently paid a dividend of $2 per share (D0 = $2.00).
The dividend is expected to grow at a constant rate of 6 percent a year (g = 6%).
The company's target capital structure is 75 percent equity and 25 percent debt.
The company's tax rate is 40 percent.
How do we compute the WACC in this circumstance? Why do we need to be concerned with the WACC?
Concept Check:
The weighted average cost of capital is the weighted average of the cost of equity and the after-tax cost of debt. Another way of looking at this is computing the effect of the capital structure on expected returns by investors.
WACC = (E/V) x re + (D/V) x Rd x (1-Tc)
Helpful Hint: One thing to bring up here is WACC is needed to determine risk on several levels. To determine risk we need to remember the following items:
Risk is deviation from expectations.
We need to set expectations for our investments in relation to risk and return. Higher risk = higher return.
Capital is obtained from the marketplace in two forms; equity and debt. This is the capital structure of a corporation and impacts the profits of a company depending on how this is managed.
We use our cost of capital to discount any cash flows from new investments (NPV and IRR analysis).
If cost of capital of the projects we undertake to increase sales rises then our risk rises and the return to our investors is reduced.
If debt rises then our obligation to make payments on interest increases and profits can decrease if sales do not increase rapidly enough.
If risk increases or returns decrease our beta will increase to show the increase in risk this will increase our required rate of return to stockholders (CAPM) and thus increase our required rate of return.
Meanwhile, a colleague of yours from IT needs help justifying the purchase of software for your department and asks for your help in justifying the investment. You agree to help because you know that this particular software will help you generate the information you need in your board presentation.
Scenario Steps to Completion
2. The company can purchase new planning software for $3,600. The software (asset) has a two-year life, will produce a savings of $600 in the first year and $4,200 in the second year.
The discount rate is 15%. Calculate the project's payback and discounted payback period assuming steady cash flows. Also calculate the project's NPV and IRR. Should the project be funded?
In light of the previous information provided, is the 15% discount rate justified. Explain your answer.
Concept Check: Payback analysis is the first step in project evaluation. The calculation enables you to understand if you can simply cover the investment within a certain time period. When doing Discounted Payback analysis or NPV analysis, a discounting rate is used to reduce future cash flows to a present value. The discount rate can be determined in many ways; existing cost of capital, projected cost of capital, desired return rate, etc as long as you justify what you wish to use for discounting cash flows and are consistent in your application evaluation will be easier.
Helpful Hint: IRR is discovered when you calculate an NPV where the result is zero (or as close to zero as you can get); this is an iterative process of adjusting the discount rate until you arrive at zero for an NPV. The best thing to do is first calculate NPV and see how far away from zero you are - you can then increase or decrease the discount rate until your NPV = zero.
Sue has another vexing problem she has been encountering with regard to capital investments. She has competing investments and has looked at them from several different perspectives and would like your input.
Scenario Steps to Completion
3. Two of the company's projects A and B have the same expected lives and initial cash outflows. However, one project's cash flows are larger in the early years, while the other project has larger cash flows in the later years. The two NPV profiles are given below:
Which of the following statements is most correct?
Project A has the smaller cash flows in the later years.
Project A has the larger cash flows in the later years.
We require information on the cost of capital in order to determine which project has larger early cash flows.
The NPV profile graph is inconsistent with the statement made in the problem.
None of the statements above is correct.
Explain and support your position.
Concept Check: NPV profile is the result of mapping the relationship between an investment's NPV and various discount rates. We begin at the r of zero on the Y axis.
Helpful Hint: It may help to place some numbers on the lines beginning with known variables.