Your next assignment as
a financial management intern is to apply the knowledge that you acquired while
engaging in the cost of capital discussion that you had with your colleagues.
In this task, you will be calculating the weighted cost of capital for a firm
using the book value of the components and the concepts presented in this
phase.
Using the most current
annual financial statements from the company you analyzed in Phase 1, determine
the percentage of the firm’s assets that are currently be financed with debt
(total liabilities), preferred stock, and common stock (common equity). It is
very possible that your firm will have very little or no preferred stock, so in
this class, the percent would be “zero.” Your ratios should add up to
100%. You will also need to calculate the firm’s average tax rate using the
income tax expense divided by the firm’s income before taxes. Use the following
tables:
|
Company |
Total Assets |
Total Liabilities |
Total Preferred Stock |
Total Common Equity |
|
Dollar |
||||
|
% |
|
Company |
Income before Tax |
Income Tax Expense |
Average Tax Rate (%) |
The first component to
determine is the cost of debt. You mentor suggests using the Web site that you
used in the previous Phase to find the pretax yield-to-maturity of a bond with
at least 5 years left before maturity. Using the following table, calculate the
firm’s after-tax cost of debt:
|
Yield to Maturity |
1 – Average Tax Rate |
After-tax Cost of Debt |
Now you will need to
calculate the cost of preferred stock. You can use the following table:
|
Annual Dividend |
Current Value of Preferred Stock |
Cost of Preferred Stock (%) |
To calculate the cost of
common equity, you can use the CAPM model. Using current stock data, the yield
on the 5-year treasury bond, and the return on the market calculated in Phase
2, you can calculate the cost of common equity using the following table:
|
5-year Treasury Bond Yield (risk-free rate) |
Stock’s Beta |
Return on the Top 500 Stocks (market return) |
Cost of Common Equity |
Now, you can use the
cost and ratios from above to calculate the firm’s weighted average cost of
capital (WACC) using the following table:
|
After-Tax Cost of Debt |
Cost of Preferred Stock |
Cost of Common Equity |
WACC |
|
|
Unweighted Cost |
||||
|
Weight of Component |
||||
|
Weighted Cost of Component |
·
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:
o How would you expect the weighted average cost
of capital (WACC) to differ if you had used market values of equity rather than
the book value of equity, and why?
o What would you expect would happen to the cost
of equity if you had to raise it by selling new equity, and why?
o If the after-tax cost of debt is always less
expensive than equity, why don’t firms use more debt and less equity?
o What are some of the advantages and
disadvantages of raising capital by using debt?
o How would “floatation costs”
impacted the WACC, and how could they have been incorporated in the formula?
Note:You can find information about the top 500
stocks atthis Web site.
Reference
S&P 500 index chart. (2014). Retrieved from the Yahoo! Finance Web
site:http://finance.yahoo.com/echarts?s=%5egspc+interactive#symbol=^gspc;range=1y;compare=;indicator=volume;charttype=area;crosshair=on;ohlcvalues=0;logscale=off;source=;
Be sure to document your
paper with in-text citations, credible sources, and list of references used in
proper APA format.
