Using some of the information you put together in Case 1 for your assigned company, we can estimate that company’s Cost of Capital.

INSTRUCTIONS TO CANDIDATES

ANSWER ALL QUESTIONS

Average Cost of Capital

Using some of the information you put together in Case 1 for your assigned company, we can estimate that company’s Cost of Capital.

1. Cost of Capital (WACC) Estimation:

a. Estimate the company’s cost of equity

i. Use the Dividend Discount Model

1. Your forecasted equity rate of return value from Case 1 value can be used here (value from questions 1c in Case 1)

ii. Use the SML/CAPM as an estimation method

1. Lookup the stock’s beta value (Yahoo Finance)

2. Use CAPM to estimate cost of equity

a. Long run value for Market Risk Premium = 7%

b. Long run value for Risk-free Rate = 3%

iii. Take an average of these 2 methods for the overall estimate of cost of equity

 

b. Estimate the company’s cost of debt using the company’s current YTM.

i. Your Case 1 part 2a value for bond yield can be used as the Pre-Tax Cost of Debt

ii. Find the company’s average tax rate

1. One method: On Morningstar, the Financial section, on the Income Statement:

Tax rate = Most recent “Provision for Income Tax” divided by Most recent “Pretax Income”

iii. Then calculate the After-Tax Cost of Debt from these values.

 

c. Estimate the capital structure weights on equity and debt by using the Market Value of Equity (Market Cap) and the Book Value of Debt (as an estimate of market value of debt). Make sure to adjust for units (millions or billions of dollars).

 

d. Estimate the firm’s weighted average cost of capital using the values above. Now we have an estimate of this company’s overall financial cost per year. This value can be used for NPV and IRR project analysis (Chapters 7 and 8)

 

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