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FIN321 Cost of Capital

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by

Kendra Thaler

on 12 December 2012

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Transcript of FIN321 Cost of Capital

Lex Service PLC
Cost of Capital Multiple Wide Discount Rate
This will Overvalue or Undervalue the company Single Wide
Discount Rate Multiple Wide
Discount Rate Multiple Wide
Discount Rate
-It will ensure the company is valued properly

- It will protect the interest of the stockowners

-It will encourage future investment into the company The Right
Choice? WACC= Wdcostd +Wecoste
Wd+We=1 and Wd=0, so We=1
WACC=0+1*coste
WACC=coste If Lex had no debt in its capital structure, what would its cost of capital be?
-Single wide Discount Rate

-Multiple wide Discount Rate
-Appropriate rates should be used
according to the business lines

-Each division carries on different
amount of risk and the cost of capital
should be accustomed to reflect each
risk and capital structure -CONS
-Most firms raise money in bulk for the entire company. So tracing individual investments for individual projects would be difficult.

-Financing costs depends on the risk of the firm, not the risk of a specific project.

-The equity holder has claims on the whole company, not just one particular project. Multiple Wide Discount Rate Cost of capital is calculated by the weighted
average cost of capital (WACC) formula, which is:

WACC= Wdcostd + Wecoste

Wd : weight of debt
costd : cost of debt
We: weight of equity
coste : cost of equity Should Lex use a single-wide corporate wide discount rate or multiple discount rates to evaluate investment projects? -PROS:
-Multiple discount rates are consistent with finance theory suggesting that such a discount rate will reflect the individual risk of the each investment. Multiple Wide
Discount Rate • With the information given and the tables in
the case CAPM is the best way to get Lex’s
estimate cost of equity.
• The CAPM:

Rs = Rf + β * (Rm – Rf) What risk-free rate did you use to
obtain your estimate? What risk premium did you use?
How did you obtain this estimate? Using the data provided in the case, estimate Lex's cost of equity under its future target capital structure for consolidated company. Risk Premium Rm = 14.68% Rf = 6.74%

Rp = Rm – Rf

Rp = 14.68 – 6.74

Rp = 7.94% Is your estimate of Lex's cost of equity appropriate as a discount rate of Lex's total operating cash flow?
Why or why not? CAPM: Rs = Rf + β * (Rm – Rf)

Rf = 7.2% β = 1.23 Rm = 14.68% Rf = 6.74%

Rs = 7.2 + 1.23 (14.68-6.74)

Rs = 16.9662 WACC Why is Lex Service PLC
concerned with its
cost of capital in 1993? In general, how can and do
companies make use
of cost of capital estimates? What role will an
estimate of cost of
capital play within Lex? Lex had a loss of 3 million in 1991

Volvo ended its 33 year agreement with Lex 1992

Lex sold near all of its share in Arrow Electronics Lex had a loss of 3 million in 1991

Volvo ended its 33 year agreement with Lex 1992

Lex sold near all of its share in Arrow Electronics - Lex had a loss of 3 million in 1991
-Volvo ended its 33 year agreement with Lex 1992
-Lex sold near all of its share in Arrow Electronics
-The decision will greatly affect
the company’s value in taking on
additional projects. Dilemma? Cost of capital= WACC

Lex used WACC as the discount rate to determine NPV of project

WACC can be used also to compare to the IRR of each project -Cost of capital= WACC
-Lex used WACC as the discount rate to determine NPV of project
-WACC can be used also to compare to the IRR of each project -Cost of capital estimates allow the company to calculate NPV of project and compare with IRR
-Allows to evaluate the riskiness of a project
-Use it as an opportunity cost If Lex operated with essentially no leverage in its capital structure and then added a moderate amount of debt, how would this affect its total value? Some effects that are changed by and addition of debt:
-Firm value
= PV FCF + PV Continuation Value + PV Interest Tax Shield
- WACC
= wdcostd + wecoste If Lex added a large
amount of debt… Problems
- Financial difficulties in repaying
- Worry anyone dealing with
the company Veronica Zermeno
Erik Pena
Michelle Aleman
Uyen Hoang
Jonathan Cruz
Kendra Thaler
Chau Tran C
A
S
E

5 To calculate the discount rates, we use the Weighted Average Cost of Capital(WACC).
Discount Rate (WACC) = (Weight of Debt x Cost of Debt) + (Weight of Equity x Cost of Equity or CAPM) What rate should we use? What rate should we use?
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