CAPITAL BUDGETING AND THE COST OF CAPITAL

1. Find out your chosen company’s credit rating. Rating agencies such as Moody’s and Standard and Poor’s assign ratings to companies. AAA is high, AA is lower, BBB is even lower,The higher the rating, the lower the cost of debt capital. Explain what your company’s credit rating is and the reasons for the high or low rating based on your research. Also, use the Fidelity Fixed Income Web page to find out what the current return is for a 30-year bond for a corporation with the rating that your company has. This yield will be the approximate cost of debt capital for your company. We will call the cost of debt RD.

2. Now estimate the cost of equity for your company. First you will need the beta; you already found this for your Module 1 SLP. You will also need the three-month treasury bill yield, which we will use as our measure of the risk-free rate. This rate should be listed on the Fidelity Fixed Income Web page linked above. Finally, you will need the equity risk premium. You can find estimates of this on many Web pages including Fidelity Fixed Income or Gutenberg Research It is usually around 5%. Once you have this information, you can estimate the cost of equity as the 30-year treasury bill yield rate plus beta multiplied by the equity premium:
Cost of Equity = risk-free rate + Beta ‘° (Equity Premium).
Show your calculations. We will call the cost of equity RE.

3. Now find out how much of the firm’s capital is equity and how much is debt. For the total value, look at the balance sheet for your company as found on Google Finance or a similar Web page. The total value of your company will be “total liabilities and shareholder’s equity.” The proportion of debt will be total liabilities divided by total value, which we will call DN. The proportion of equity will be shareholder’s equity divided by total value, or EN. If you calculate them correctly, the proportions will add up to one. 4. Now we have all the information we need to get at least a rough ballpark estimate of WACC. Let’s assume a corporate tax rate of 35%. So the formula we will use is WACC = (EN)* RE +(DN)• RD *(1,35)
Calculate WACC and show your computations. As a “reality check” on your calculations, the WACC should likely be in the single digits and positive. Compare what you found to the average WACC in your company’s industry, which should be available on Web pages such as Cost of Capital by Sector (US). Note that 35% is the official corporate tax rate, but many corporations find tax breaks. If your WACC is too low, try computing it with a lower tax rate such as 25% or 10%. SLP Assignment Expectations • Answer the assignment questions directly. • Stay focused on the precise assignment questions. Do not go off on tangents or ittgab-Siiiitids’atetto summarizing general background materials.

 

 

 

 

 

 

 

 

 

 

Sample Solution

ACED ESSAYS