Name ____________________________ Financial Analysis Exercise IV Part A: Weighte
ID: 2741310 • Letter: N
Question
Name ____________________________
Financial Analysis Exercise IV
Part A: Weighted Average Cost of Capital (WACC)
Here again is the formula for WACC. For simplicity the term for preferred stock has been removed:
Go to http://thatswacc.com/[1] and enter the ticker symbol for the stock you selected and click on the tab entitled “Calculate WACC.”
Complete the following tables:
Name of Company/Stock
International Business Machines
Ticker Symbol
IBM
From the http://thatswacc.com/ results for your company:
WACC
7.48%
Cost of debt, iD
1.16%
Corporate tax rate, TC
18.12%
Total debt, D
$39,889,000
Total equity, E
$142,900,000,000
Total firm value, V
$183,205,500,000
Cost of equity, iE
9.32%
CAPM Components
Beta,
.79
Historical market return, iM
Assumed 11%
Risk-free rate, iF
Assumed 3%
Using data in the table confirm the accuracy of the site’s WACC calculation:
Weight of Equity
78.33%
Weighted Average Cost of Equity
E
7.30%
Weight of Debt
21.67%.
Pre-Tax Weighted Average Cost of Debt
D
.251%
After-Tax Weighted Cost of Debt
D · (1- TC)
.206%
Weighted Average Cost of Capital
= · iE + · iD · (1-Tc)
7.51%
Part B: Dividend Payout and Growth Ratios
Recall from Module 1 the following two ratios:
Internal growth rate = (ROA RR) / [1-(ROA RR)] (Eq. 3-30)
where RR = Retention ratio = (Addition to retained earnings)/Net income (Eq. 3-31)
The internal growth rate measures the amount of growth a firm can sustain if it uses only internal financing (retained earnings) to increase assets
Sustainable growth rate = (ROE RR) / [1-(ROE RR)] (Eq. 3-33)
If the firm uses retained earnings to support asset growth, the firm’s capital structure will change over time, i.e., the share of equity will increase relative to debt
To maintain the same capital structure managers must use both debt and equity financing to support asset growth
The sustainable growth rate measures the amount of growth a firm can achieve using internal equity and maintaining a constant debt ratio
1. For the firm selected for Part A, calculate its internal growth rate for the last fiscal year:
= (ROA RR) / [1-(ROA RR)]
=(.1194*.6316)/(.1194*6316)
=.07542/.92458
=.0815 or 8.15%
2. Calculate the firm’s sustainable growth rate for the last fiscal year:
= (ROE RR) / [1-(ROE RR)]
=(.9248*.6316)/(1-(.9248*.6316))
=.5841/.4159
=1.4047
=140.47%
Part C.
Consider your results for Parts A and B. If the chosen firm grows at its internal growth rate, increasing assets only with its retained earnings, how will this likely affect its WACC? Show calculations.
If the chosen firm grows at its sustainable growth rate with increases in both its retained earnings and debt, maintaining a constant debt ratio, how will this affect its WACC?
If the chosen firm attempts to grow faster than its sustainable growth rate with modest increases in its debt ratio, how will this likely affect its WACC? What about very large increases in its debt ratio? Explain.
Appendix
Should the Web site http://thatswacc.com/ not be available, please follow the instructions below that have been posted at http://thatswacc.com/faccs.php on how to calculate the terms in WACC.
The components of the WACC equation are calculated using the following financial data:
From the firm’s balance sheets:
Period ending
Last Fiscal Year
Last Fiscal Year -1
Last Fiscal Year -2
Short term debt + Current portion of long term debt (CMLTD)
Long Term Debt
Total debt, D
From the from the firm’s income statements:
Period ending
Last Fiscal Year
Last Fiscal Year -1
Last Fiscal Year -2
Interest expense
Income before tax
Income tax
Other data:
Firm’s current market capitalization (intraday stock price shares outstanding)
See below.
Firm’s beta,
See below.
Return on the market, iM
Assume 11%
Risk-free rate, iF
Assume 3%
The calculations in the table are based on the following:
Total debt, D, is the sum of Short term debt + CMLTD + Long Term Debt
Total equity, E, is the firm’s current market capitalization = current stock price times the number of shares outstanding. [Should http://thatswacc.com/ not be available, Market capitalization is available on the “Summary” page at the Yahoo Finance (http://finance.yahoo.com/) site for the stock.]
Total value of the firm, V, equals Total debt, D, + Total equity, E
Cost of debt, iD, = Interest pd in most recent fiscal yr/(Sum of total debt in last two fiscal yrs/2)
iD = Interest expense/Average debt
Corporate tax, Tc, the firm’s corporate tax rate = Sum of prior three fiscal yrs’ Income tax expense/ Prior three yrs’ Income before tax
TC = Average Tax Expense/Average Income Before Tax
Firm’s cost of equity,
In the table if is assumed to equal 0.03 and iM is assumed to equal 11%. [Should http://thatswacc.com/ not be available, the firm’s beta, E, is available on the “Summary” page at the Yahoo Finance (http://finance.yahoo.com/) site for the stock.]
[1] The accessibility of this site is assumed. Should it not be accessible, please follow the instructions in the Appendix at the end of this document.
Name of Company/Stock
International Business Machines
Ticker Symbol
IBM
Explanation / Answer
i). Firm chooses to grow at internal growth rate using only its retained earnings: In this case the firms asset will grow at the internal growth rate. It will be funded by an equal amount of growth in equtiy and no growth in its debt.
Total Value = 183,205,500,000 (given);
Weight of Debt = 21.67% (given); Weight of equtiy=78.33% (given)
Equity Value = 78.33% x 183,205,500,000 = 143504868150
Debt Value = 21.67% x 183,205,500,000 = 40305500000
Internal Growth Rate as calculated in 1. Part A of the question = 8.15%
Total Firm Value next Year = 183,205,500,000 x (1+8.15%) = 198,136,748,250
Debt will remain constant at 40305500000
New Equity Value = 198,136,748,250 - 40305500000 = 157831248250
Weight of Debt (wd) = 40305500000/198136748250 = 20.3422%
Weight of Equity(we) = (100-20.3422)% = 79.65%
WACC = we x iE + wd x iD x (1-Tc) = 79.65% x 9.32% + 20.34% x 1.16% x (1-18.12%) = 7.62% (iD, iE, Tc are given)
So, the WACC has increased from 7.51% to 7.62%
ii) If the firms maintains constant debt ratio: In this case the WACC would not change and would remain at 7.51% since no component in calculation of WACC is changing
iii) If the debt ratio increase by modest amount and if there is very large increase in debt ratio:
In case there is modest increase in debt ratio the WACC would decrease. This is because debt is cheaper than equity and interest on debt is tax deductible. As the weight of debt in capital structure increases that means the cheaper component of WACC is increasing. So, the WACC will decrease.
Incase of large increase in debt ratio the WACC would increase. If the debt level goes beyond a certain level at which the risk increases leading to increase in cost of debt (as the credit rating of company would fall) and cost of equity will also increase (due to increase in beta as beta is dependent on debt ratio). The overall effect will increase in WACC
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