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Finance 3 Pages

Wacc

Question

Calculate the weighted average cost of capital (WACC) using the market value of equity to determine a more realistic cost of capital. Visit a Web site to get the current value of the common stock price per share and multiply this value times the most recent number of shares of common stock outstanding. In this exercise, you will be ignoring preferred stock because its weight value will most likely be too low to impact the final result. You may use the following table to complete this portion of the task:

CompanyCommon Stock, price per shareNumber of Common Shares OutstandingMarket Value of Common Equity
    

Now, you can estimate the total market value of the company by adding the book value of total liabilities to the market value of the firm’s common equity and determine their market value weights.

CompanyTotal LiabilitiesMarket Value of Common EquityMarket Value of the Firm
Values   
Weights   

Using the cost of each component as determined in the Phase 4 IP, calculate the firm's market value WACC.

 After-Tax Cost of DebtCost of Common EquityWACC
Unweighted Cost   
Market Weight of Component   
Market Weighted Cost of Component   

The firm is considering investing in a capital project that will have an initial cost of $12 million. The project is expected to have a productive life of 5 years, and at the end of this period, it is expected to have a salvage value of $2 million. The net value of the project will be depreciated using the straight-line method for the full 5 years. The project is expected to increase the firm’s revenue by $10 million per year, and related expenses (not including depreciation) are expected to increase by about $6.5 million per year.

The first thing you need to do is calculate the annual depreciation. Feel free to use the following table:

Initial Investment 
less Salvage Value 
Depreciable Value 
Life of Project (years) 
Depreciation/year 

Now, you need to calculate the relevant cash flows for the project. You can use the average tax rate that was calculated in Phase 4 to determine the additional taxes the firm will have to pay. The following template may be of some assistance to you:

Years012345
Initial Investment (negative)      
Increase in Revenue      
Less Increase in Operating Expenses      
Increase in Operating Income      
Less Depreciation/year      
Taxable Income      
Less Taxes at Average Rate      
Net Income      
Plus Depreciation/year      
Operating Cash Flow      
Plus Salvage Value (Year 5)         
Relevant Cash Flows (0–5)      

At this point, you are ready to apply the capital budgeting techniques of net present value (NPV) and the internal rate of return (IRR). To calculate the NPV, use the market-value WACC as your discount rate and the required rate of return for IRR.

  • After completing the required calculations, explain your results in a Word document, and attach the spreadsheet showing your work. Be sure to explain the following:
    • Based on your calculations, would you recommend approving or rejecting the project, and why?
    • Why would you expect both NPV and IRR to support the same conclusion to accept or reject the project?
    • If you employed a cost of capital of 20%, would you have made the same accept or reject decision, and why?
    • What are some of the advantages and disadvantages of the 2 methods (NPV and IRR), and under what circumstances is one more reliable over the other?

Why is operating cash flow used in capital budgeting and not net income?

Solution

Title: Wacc
Length: 3 pages (902 Words)
Style: APA

Preview

Determination of the market value of the firm 

The analysis was based on Tesco Plc. a supermarket chain whose home market is in the United Kingdom. The share price as per the end of the year 2014 on which the study is based is £230. The amount of shares outstanding as at December 2014 are 80,680,000. The market value as of the same date is determined to be £8,556,400,000.

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