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The WACC:
First, to compute the WACC, I'm only interested in using the CAPM for the cost of equity. For simplicity, let's agree on the following parameters: Risk free rate: 4%; Market Risk Premium: 7%; Potash Corporation (POT) Beta = 1.15
Second, to be precise, we use market value determined weights. However, from a practical perspective, it isn't such a crucial point, nor does it make a significant difference, with respect to the firm's debt or preferred, unless convertibles. So for non-convertibles debt and preferred, it makes most sense to use book values. Use market values for common equity, and convertible debt and preferreds, and consider convertibles at par or above to be equity. However, do use your best estimates of market rates/yields for non-convertible debt and preferreds.
PART 2:
M&M Capital Structure Analysis:
What we want to do is to create the data that allows you to create the equivalent of below (M&M – Static Theory), which is not as difficult as you might think.
But before we do, let's briefly discuss what to do with preferreds. Those who were in my Finance 1 class might recall that on several occasions, I suggested that my view of preferreds is that they are a very subordinated form of debt with the payments treated differently from tax purposes: from the firm's perpective they're paid out of after-tax income. Therefore, you will need to compute a pre-tax equivalent cost (or yield) to make them comparable to debt.
kP,BT = kP/(1-TC)
So a firm that has a preferred share yielding 6% that has an effective tax rate of 25% would have an equivalent pretax cost of 6%/(1-0.75) = 8%
Now let’s focus on what is needed to create your firm’s M&M – Static Theory graph(shown above).
First, several points on the graph are known to you. The first set of points is from the WACC calculation: you have the (1) cost of debt, (2) cost of equity and (3) WACC form the firm’s current DE Ratio. Secondly, we know that the cost of equity line if a linear function of the DE ratio: kE = rf + b[MRP] and bL = bU[1+(1-TC)(D/E)], so at the axis, we would use the unlevered beta and for any intermediate point we simply compute the appropriate levered beta to get the cost of equity.
The trickiest will be tracing out the cost of debt.
Method #1: If you have access to the yields on all the firm’s existing debt and preferred, it would simply be necessary to reorder them from cheapest to most expensive and simply compute the weighted average cost of debt (and preferred) up to any specific DE level. (The value of the cost of debt line/curve at any DE level is the average cost of debt and preferred up to that DE level, NOT the marginal or incremental cost.)
Method #2: The cost of debt curve will not be a straight line, but a slightly convex (from the bottom) curve, which you might be able to model. In either case, the y-axis value for the cost of debt would likely be the after-tax AAA rate for debt. (Actually, it is more likely an AA rating, since only 4 companies have a AAA rating: ADP, J&J, Microsoft and ExxonMobil.) How much curvature you model in will depend on the amount if debt and the firm’s financial health and debt rating.
Once you have modelled the cost of debt line, the WACC line computes quite easily. Remember D/V = (DE/(1+DE)) and E/V = (1/1+D/E).
Deliverables:
I expect that you should submit:
- A WACC spreadsheet
- A M&M Static Thoery Graph with the appropriate spreadsheet backup
- A commentary of up to 250 words on the optimality of the firm’s capital structure (please analyze in an M&M context whether the firm has optimized its capital structure, i.e., is it using too much debt, too little debt or are you satisfied that the firm is making optimal use of debt.)
- Innovation Company is thinking about marketing a new software product. Upfront costs to market and develop the product are $5 million. The product is expected to generate profits of $1 million per year for 10 years. The company will have to provide product support expected to cost $100,000 per year in perpetuity. Assume all profits and expenses occur at the end of the year.
- What is the NPV of this investment if the cost of capital is 6%? Should the firm undertake the project? Repeat the analysis for discount rate of 2% and 12%?
- How many IRRs does this investment opportunity have?
Question 2:
3. You are considering opening a new plant. The plant will cost $100 million upfront. After that, it is expected to produce profits of $30 million at the end of every year. The cash flows are expected to last forever: Calculate the NPV of this investment opportunity if your cost of capital is 8%. Should you make the investment? Calculate the IRR and use it to determine the maximum deviation allowable in the cost of capital estimate to leave the decision unchanged.
The Internal Rate of Return Rule
c. Can the IRR rule be used to evaluate this investment? Explain.
Choosing Between Projects
24.You work for an outdoor play structure manufacturing company and are trying to decide between two projects.
Year-End Cash Flow ($ thousands)
Project 0 1 2 IRR
Playhouse -30 15 20 10.4%
Fort -80 39 52 8.6 %
You can undertake only one project. If your cost of capital is 8%, use the incremental IRR rule to make the correct decision.
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