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?
