Tag: WACC

Explain what would occur if EPC were to use a single corporate-wide WACC for evaluating investment opportunities in each of its lines of business? What would be the likely consequence for the company over time if this were to occur?

Case 5

Recommend weighted average costs of capital (i.e., WACCs) for EPC’s consumer
products, medical devices, and pharmaceuticals divisions respectively? (Remember to
unlever comparable company betas and to use average betas of the comparable
companies in calculating divisional WACCs. Then remember to relever the beta to
represent the target leverage ratio in market value terms.)

2. Recommend the types of investments that should be evaluated using EPC’s divisional
WACCs?

3. Explain what would occur if EPC were to use a single corporate-wide WACC for
evaluating investment opportunities in each of its lines of business? What would be the
likely consequence for the company over time if this were to occur?

4. Calculate EPC’s corporate-wide WACC. (Remember, EPC’s corporate-wide beta is
1.04. This beta is based on EPC’s historical market leverage ratio.)

Identify and describe a long-term investment project (either real or fictional) that would likely require significant capital commitment.Regardless of these factors, why might this project still be a worthy investment? Are there certain industries that might demand a more long-term strategy? Which ones? In your responses to your peers, compare and contrast your views with your classmates’ observations.

Discussion 2-1 FIN 660

Why might companies disregard a positive NPV? MIT professor of financial economics Stewart C. Myers asserts that different decision rules might apply when investments are long-term rather than short-term (Myers, 1977). Financial managers may rationalize that it is in their immediate interest to invest in short-term projects because they bring the most shareholder benefits; this is, in other words, the so-called agency problem. However, what could be the long-term consequences of that strategy? Watch the short agency problem video (7:14) below for an explanation of this conundrum in detail with good examples.

Identify and describe a long-term investment project (either real or fictional) that would likely require significant capital commitment.

If you were acting as a financial analyst, what factors would you consider in the decision to move forward or abandon the project? In your initial response, you may discuss such factors as:

NPV
IRR
EBIT
WACC
Corporate structure
Market structure
Corporate goals and mission

Regardless of these factors, why might this project still be a worthy investment? Are there certain industries that might demand a more long-term strategy? Which ones? In your responses to your peers, compare and contrast your views with your classmates’ observations.

The current corporate tax rate in the U.S. is 21%. There are tax increases in the works for 2021. The Biden administration proposed to raise the corporate tax rate from 21% to 28%. If the proposal is approved, how does that affect the WACC and the NPV?

Calculation of net present value and writing

Name two assumptions you implicitly make when you apply the WACC method to evaluate the project for your company. Recall the WACC method can only produce creditable results when certain assumptions hold. (You can find hints from Lecture Note 11.) Discuss whether these two assumptions are likely to hold for the project you choose.
The choice of risk‐free rate. We used the 5‐year U.S. Treasury yield as our risk‐free rate. Explain why this choice is reasonable or not.

You can find hints from the PPT ‐ Implementing CAPM of Lecture 10.
Cost of debt estimation. For a company without credit ratings, two methods are introduced to estimate its cost of debt (see the instruction 2.a.i above)

Use the debt beta of 0.31, the debt beta for CCC rated firms in Table 12.3, and apply the CAPM to estimate its cost of debt.

Use the weighted average of interest rates for its bank loans as a proxy for its cost of debt.

If the company does have a credit quality lower than the CCC rated firms, does your estimate based on method 1 overestimate or underestimate your company’s true cost of debt? Does your estimate based on method 2 overestimate or underestimate your company’s true cost of debt? Explain why? Recall that the cost of debt is the expected return required a firm’s creditors.

Cost of debt estimation. For a company that has bonds outstanding, based on its coupon payments, remaining maturity, and current price, we can estimate its yield to maturity (YTM). Does the YTM overestimate or underestimate your company’s true cost of debt? You can find hints from Lecture Note 4.

Equity beta.Is your company’s equity beta larger than 1 or smaller than 1? What does it tell you? Give your intuitive explanations. You can find hints from Lecture Note 9 ‐ Risk and Return ‐ Part II and the slides 6 and 7 in Lecture Note 10.

The current corporate tax rate in the U.S. is 21%. There are tax increases in the works for 2021. The Biden administration proposed to raise the corporate tax rate from 21% to 28%. If the proposal is approved, how does that affect the WACC and the NPV?

Explain why it is appropriate for Optimus to value the Electrobicycle project using its WACC.

 

Imagine that you own a company, Optimus, Inc., which is funded with 40% debt and 60% common stock; there is no preferred stock in the capital structure. The debt has an after-tax cost of 4%. You have studied the Electrobicycle project, and you believe that the auto company who has done the research and development (R&D) has made a crucial mistake. You believe that after the first 5 years, there will be worldwide expansion opportunities and many more years of revenues and earnings from selling Electrobicycles. Thus, you would not shut down the project in Year 5. Instead, you believe you will be able to sell the Electrobicycle business in Year 5 to a multinational company that will continue to produce the products and sell them internationally for many years into the future. You believe the sale of the Electrobicycle business in Year 5 will be for at least $15.0 million. Thus, you believe the value of the Electrobicycle project is significantly higher than the auto company realizes.

For the initial post,

Calculate Optimus’ required rate of return on equity using the capital asset pricing model (CAPM). For the CAPM, use the following assumptions:

Use a risk-free rate of 4.0%.

Use 6.0% as the market risk premium.

For the beta, use the beta below, according to the first letter of your first name

First Letter of First Name Beta

A through B 0.30

C through D 0.40

E through F 0.50

G through H 0.60

I through J 0.70

K through L 0.80

M through N 0.90

O through P 1.00

Q through R 1.10

S through T 1.20

U through V 1.30

W through Z 1.40

Calculate the WACC for Optimus. As a reminder, Optimus is funded with 40% debt and 60% common stock; there is no preferred stock in the capital structure. The debt has an after-tax cost of 4%.

Use the Optimus required rate of return on equity that you calculated using the CAPM.

Explain why it is appropriate for Optimus to value the Electrobicycle project using its WACC. Compare using the WACC to using solely the cost of equity in valuing the Electrobicycle project.