BA 5802 Financial Management Case Study 2 Emre BULUT Lex Service PLC – Cost of Capital 2056281 Questions: 1. Why is Lex Service PLC concerned about its cost of capital in 1993? What role will an estimate of the cost of capital play within Lex? In general, how can and do companies make use of cost of capital estimates? Since there are significant changes in the company for the last 3 years such as descending trend in car and truck market in 1991, sale of one of their core electronics business, terminated Volvo agreement etc.; the company thinks that their financial value (equity and debt ratios and weights) and accordingly cost of capital is changed. Also company has free cash (derived from the sales of electronics …show more content…
As risk premium given average on long term equity annual return is used. Since it is not easy to observe the market premium, long term historical data on equity return is better. c. Is your estimate of Lex’s cost of equity appropriate as a discount rate for Lex’s total operating cash flows? Why or why not? For future cash flows, evaluation is done with WACC rate which consists from cost of equity and cost of debt in a weighted average. In this case, using cost of equity is not appropriate since we doesn’t know cost of debt and weights of equity and debt, it doesn’t reflect the actual rate for WACC. 3. If Lex had no debt in its capital structure, what would be its cost of capital? How could this estimate be used to value Lex? If Lex operated with essentially no leverage in its capital structure and then added a moderate amount of debt, how would this affect its total value? How might we capture this value impact of debt in our valuation analysis? If company doesn’t have any debt, it means that WACC is equal to cost of equity. There are two ways of increasing capital, (1) using debt and (2) issuing new shares. For profitable companies sometimes it is cheaper to use debt instead of issuing new shares since cost of debt is tax shielded. In this case company didn’t have any debt in past which means less default risk, it will affect total value in a positive way. It will decrease the taxes paid and increase net income, accordingly share values. 4.
Then we can use the following formula to calculate the WACC. The cost of debt is taken to be on an after tax basis to further to account for the depreciation tax shield.
Free Cash Flow = Sales Revenues – Operating Costs and Taxes – Required Investments in Operating Capital. Weighted Average Cost of Capital (WACC) is affected by market interest rates, market risk aversion, cost of debt, cost of equity, firm’s debt/equity mix, and firm’s business risk. Therefore, free cash flows and the weighted average cost of capital interact to determine a firm’s value by the following equation:
To relever the βe, we use the formula, βe = βu +(D/E)*(βu-βd). And the “Target D/E” was found by taking “Target D/V” divided by “1-Target D/V”. So we get the new βe, 1.3576. Then to get cost of equity, we use the CAPM formula, Re=Rf+β(EMRP), 11.7679%. Since we have get the cost of equity and cost of debt, we can determined the WACC, which is equal to Equity/Value*Cost of Equity+Debt/Value*Cost of Debt*(1-tax rate). In the end ,we arrived at 8.48%.
Barb Williams and Rick Thomas, while attending an executive education course at a well-known business school, came across a case which involved calculating the cost of capital for Telus Corporation (Telus). Basic data such as the Balance Sheet, Income Statement, Data on Telus’ Common Stock, Market Index, and the Average Annual Returns in North American Capital Markets were provided. In order to calculate Telus’ cost of capital we need to calculate the company’s Cost of Equity, Cost of Debt, and Tax Rate along with their weighted cost and then apply these to the Weighted
I used WACC as the discount factor, we expect the rate of return to be higher than it, the same at least. The WACC reflects the average risk and overall capital structure of the entire firm [2]. It’s the required return and it presents how much the company pays for the capital it finances. In this case, the cost of equity is 10.33%, the cost of debt is 6.50%. I calculated WACC using those numbers and got a result of 8.49%.
This assignment will calculate the Weighted Average Cost of Capital of AGL Energy Ltd and gearing, as well as analysing the capital structure of the company. Through this, recommendations can be given to the firm to increase and better manage capital and how it is used. The Weighted Average Cost of Capital (WACC) is a calculation of a firm 's cost of capital. It is the average costs of debt and equity financing, each of which is weighted by its proportional
The mixture of debt-equity mix is important so as to maximize the stock price of the Costco. However, it will be significant to consider the Weighted Average Cost of Capital (WACC) as well so that it can evaluate the company targeted capital structure. Cost of capital (OC) may be used by the companies as for long term decision making, so industries that faced to take the important of Cost of capital seriously may not make the right choice by choosing the right project(Gitman’s, ).
In estimating the weighted average cost of capital, we used the cost of equity of 11.63% and the cost of debt of 2.25%. We calculated the weight of debt to be 2% and the weight of equity to be 98%. For the weight of debt we divided debt by the sum of debt and equity, and for the weight of equity we divided equity by the sum of debt and equity. Our estimated Company’s cost of capital is 11.44%, or 12%. The calculations for the cost of capital are shown in Appendix E.
Discounted cash flow analysis in Exhibit 12 We do not know the beta for Interco’s equity. Therefore, it is not possible for us to estimate the weighted average cost of capital (WACC) for Interco. Note that here WACC method is appropriate because Interco is not
At first, WACC and CAPM was attempted to be used as a source of cost of capital. However, for WACC, there is no available proportion of debt and cost of debt for MW. For CAPM, no available data seems to support the acceptable
Solutions to Valuation Questions 1. Assume you expect a company’s net income to remain stable at $1,100 for all future years, and you expect all earnings to be distributed to stockholders at the end of each year, so that common equity also remains stable for all future years (assumes clean surplus). Also, assume the company’s β = 1.5, the market risk premium is 4% and the 20-30 year yield on risk free treasury bonds is 5%. Finally, assume the company has 1,000 shares of common stock outstanding. a. Use the CAPM to estimate the company’s equity cost of capital. • re = RF + β * (RM – RF) = 0.05 + 1.5 * 0.04 = 11% b. Compute the expected net distributions to stockholders for each future year. • D = NI – ΔCE = $1,100 – 0 = $1,100 c. Use the
As long-term valuation is assumed, risk free rate is set as 30-year treasury rate, 5.73%. Cost of debt is 6.72% reflecting Amoco’s credit level. Cost of equity is calculated as 10.63%, leading to final WACC at 8.85% (Chart 1).
With all the above aspects considered, Adecco arrived at a debt portion of WACC equal to .96% and an equity portion of 9.31% resulting in an overall WACC of 10.27%. This was calculated utilizing a beta of equity considering a beta of debt and assets of 0.2 and 0.48 respectively. Utilizing the free cash
The relationship between capital structure and firm value has been discussed frequently in the literature by different researcher accordingly, in both theoretical and empirical studies. It has also been discussed that whether the firm has any optimal capital structure that has been adopted by an individual firm, or whether the proportions of debt usage is completely irrelevant to the individual firm value.