# Project #37586 - Assignment

These are my answers to the two discussion questions. All I need is a response (2-3 sentences total, 2 statements and/or a question) to the four responses like before. Try to let your responses agree to the answers I have responded with.

Question 1

To make accurate accept or reject decisions, it is important for an organization to determine its WACC. Not all organizations have preferred stock in their capital structures; in such a situation, an organization's weighting for preferred stock in the WACC would be zero. Although organizations get an interest deduction from debt, they find that if they use too much debt in their capital structures, the cost of debt rises because of the increased risk of bankruptcy from such a scenario.

To make accept or reject decisions, it is important for an organization to compute discount rates.

• What are the various ways in which an organization computes its cost of equity?
• How does an organization compute its cost of debt?
• How does an organization compute its overall WACC?

Justify your answers using examples and reasoning. Comment on the postings of at least two peers and indicate whether you agree or disagree with their views.

Firms seek capital mainly from lenders and shareholders. Because of this, firms need to reward them differently. A firms cost of equity need to be estimated based on market forces and there are various ways that firms use to estimate the cost of equity. Among the main ways of estimating the cost of equity, include the capital asset pricing model, discounted cash flows, the bond yield plus risk premium (BYPRP), among others.

The cost of debt is an effective rate that any company pays on its current debt obligations. The two main ways through which the cost of debt is determined is through the after tax returns and the before-tax returns. Because interest expense is deductible, the after-tax rate is usually preferred. The before tax rate is applied as it is i.e. 5% if this is the tax rate, on the other hand the after-tax rate is given by (before-tax rate* (1-marginal tax)).

Question1/Response1

A company can compute their cost of equity a few ways.  One way is they can simply the dividend growth model where the nest year's annual dividend are divided by the current stock price and then the dividend growth rate is added to that number to give the company their cost of equity (Ross, Westerfield, & Jaffe, 2013).  Another way is by using the Capital Asset Pricing Model (CAPM), and this formula involves using the company's rate of return on risk-free securities, the beta of the securities, and the overall expected rate of return of the market (Ross et al., 2013).  Also the discount rate can be used to show the firm's cost of equity if the firm is all equity (Ross et al., 2013).

A company can estimate their cost of debt by the following formula:  aftertax cost of debt = (1 - tax rate) x the borrowing rate (Ross et al., 2013).  A company can even calculate the cost of the preferred stock by simply dividing the preferred dividends by the net issuing price, and this way they can see how much the company is expected to pay out their their preferred stock holders (Ross et al., 2013).

The weighted average cost of capital (WACC) is normally calculated using the average cost of capital because it weights the cost of equity and the cost of debt (Ross et al., 2013).  The WACC is the percentage of financing through equity times the cost of equity added to the percentage of financing through debt times the cost of debt all multiplied to 1 minus the corporate tax rate (Ross et al., 2013).

Reference:

Ross, S. A., Westerfield, R. W., & Jaffe, J. (2010).Corporate finance.
New York: McGraw-Hill.

Question1/Response2

The cost of equity is a part of the company's capital structure. The cost of equity measures the returns demanded by the stock market investors who will bear the risks of the ownership. The COE is also expressed as an annual percentage. The high cost of equity indicates that the market views the company's future as risky and with this it requires greater return rates. A lower cost of equity indicates the opposite. The cost of equity is a central concern to potential investors applying the capital asset pricing model (CAPM), who are attempting to balance expected rewards against the risks of buying and also holding the company's stock. An accurate estimate of the COE for a rate regulated company would need to consider that the levels of financial risk in the companies used to estimate the COE and also how the levels compare to the level implied by the company's regulatory capital structure.

The cost of debt for an organization is the effective rate that it pays on all of its debts and the part of which typically consist of bonds and bank loans. The cost of debt is also the part of a company's capital structure. The cost of debt could also be expressed as a percentage in two different ways: before tax or after tax. In some cases where the interest expenses are tax deductible, the after tax approach is generally considered more accurate. Then the after tax cost of debt is always lower than the before tax.

After the tax cost of debt = (Before the tax cost of debt) X (1 - marginal tax rate).

When it comes to Weighted average cost of capital (WACC) is not the same thing as cost of debt because WACC can include sources of equity funding as well as debt financing. Cost of capital may differ for funds raised with bank  loans or sales of bonds. To find the appropriate cost of capital for the firm the WACC is calculated. Calculating WACC is a matter of summing the capital cost components, where each is multiplied by its proportional weight.

WACC = (Proportion of the total funding that is equity funding) X (Cost of the equity) + (Proportion of the total funding that is debt funding) X ( Cost of Debt) X (1 - Corporate tax rate).

www.accounting-financialtax.org
www.expectationsinvesting.com

Question 2

An organization can only control some of the factors with the WACC. For example, it does not have much control over the tax rates that are set up by the government. The tax rate has a significant impact on the after-tax cost of debt since organizations get an interest deduction from debt. Organizations can decide how to finance their businesses; some may decide that it is too expensive to issue common equity and may just rely on debt and preferred stock.

Financial analysts often use the WACC to evaluate their projects. However, at times they are unsuccessful in correctly evaluating projects. What according to you could be some of the problems with using the WACC? Support your answer with rationales.

Comment on the postings of at least two peers and indicate whether you agree or disagree with their views.

The weighted average cost of capital is the rate of return given by the proportion of equity and debt that a firm uses to finance its operations. The weighted average cost of capital shows the financial health of a company and is used for internal and external purposes. The weighted average cost of capital (WACC) is given by the following formula WACC = DP × DC − T + EP × EC, where DP is the proportion of debt financing, DC is the cost of debt, T is the tax rate, EP is equity financing, and EC is cost of equity.

Some problems arise with WACC. These include the fact that there is need to be sure of the real rates of taxation for each form of financing because they do not always carry the same rates of taxation. The WACC should also not be used to compute the cost of capital of risky projects.

Question2/Response1

When deciding how to finance a project or set up an organization’s capital structure managers frequently use the WACC formula. The WACC formula is a straight forward method to determining the weighted average cost of income from their sources, but frequently WACC evaluations prove inaccurate. This inaccuracy is inherent to the individual parts of the WACC formula. Each part of the WACC requires estimates or assumptions of future returns and government tax rates (Ross, Westerfield, & Jaffe, 2010). The WACC formula is:

WACC = (% equity) x (Cost of equity) + (% debt) x (Cost of Debt) x (1 – Corporate tax rate)

In the formula, the cost of equity using the CAPM or dividend growth model must project the return on the market or next year’s annual dividend. Likewise the cost of debt, assumes that government tax will remain constant. The company can only control the weighting of its capital structure, but the variables which determine the cost of each variable are based on estimates and assumptions.

References:

Ross, S. A., Westerfield, R. W., & Jaffe, J. (2010). Corporate finance. New York: McGraw-Hill.

Question2/Response2

WACC is expressed as a percentage, like interest. An example if a company works with a WACC of 12%, that means that only investments should be made that give a return higher than the WACC of 12%. The easy part of WACC is the debt part of it. In many cases it is clear on how much a company has to pay their bankers for debt finance.

In brief, WACC shows the overall average rate the company pays for funds it raises. In many organizations, WACC is the rate of choice to use for discounted cash flow (DCF) analysis to evaluate potential investments and business cash flow scenarios. However, financial officers may choose to use a higher discount rate for DCF analysis of investments and actions that are perceived riskier than the firm's own prospects for survival and growth.

While the relative debt and equity values can be easily determined, calculating the costs of debt and equity can be problematic.

The problem inherent in different methods used to calculate cost of equity is that at leastone component is an estimate.

The terms of risk free bonds used in determining cost of debt may not always adequately match the terms of the company's debt.

 Subject Mathematics Due By (Pacific Time) 08/12/2014 12:00 pm
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