Essentials of finance.
In the constant growth formula, you can use the required rate of return on equity to determine the value of a share of stock. However, when you are computing the value of an investment project, you cannot assume the project is entirely funded by equity. Most businesses, and most projects, are funded with a combination of debt and equity financing. As a result, the discount rate for the project has to reflect the required rates of return for the debt holders and the equity holders. Analysts compute the weighted average cost of capital (the WACC) to value projects. The WACC is a weighted average of the required returns for the debt and equity holders, based on the proportions of debt and equity in the capital structure. In this discussion, you will practice calculating the WACC and interpreting its meaning and application.
Imagine that you own a company, Optimus, Inc., which is funded with 40% debt and 60% common stock; there is no preferred stock in the capital structure. The debt has an after-tax cost of 4%. You have studied the Electrobicycle project, and you believe that the auto company who has done the research and development (R&D) has made a crucial mistake. You believe that after the first 5 years, there will be worldwide expansion opportunities and many more years of revenues and earnings from selling Electrobicycles. Thus, you would not shut down the project in Year 5. Instead, you believe you will be able to sell the Electrobicycle business in Year 5 to a multinational company that will continue to produce the products and sell them internationally for many years into the future. You believe the sale of the Electrobicycle business in Year 5 will be for at least $15.0 million. Thus, you believe the value of the Electrobicycle project is significantly higher than the auto company realizes.
For the initial post,
● Calculate Optimus’ required rate of return on equity using the capital asset pricing model (CAPM). For the CAPM, use the following assumptions:
○ Use a risk-free rate of 4.0%.
○ Use 6.0% as the market risk premium.
The BETA to use is “0.50”!!!
● Calculate the WACC for Optimus. As a reminder, Optimus is funded with 40% debt and 60% common stock; there is no preferred stock in the capital structure. The debt has an after-tax cost of 4%.
○ Use the Optimus required rate of return on equity that you calculated using the CAPM.
● Explain why it is appropriate for Optimus to value the Electrobicycle project using its WACC. Compare using the WACC to using solely the cost of equity in valuing the Electrobicycle project.