In other words, the cost of raising fund is the firm’s cost of capital. Estimate a firm’s cost of capital is important because can help conclude required return for capital budgeting projects. Usually, the investor only picks up the project which provides higher return and lower risk on investments. Since the cost of capital is the minimum return required by investors, manager should invest only in projects that generate returns in excess of the cost of capital. Cost of capital can help define the acceptability of investment opportunities.
It helps for forecasting on making certain financial decisions. The three groups that use these ratios are managers, potential investors or lenders, and stockholders. The reason the managers use these ratios, is to have a closer look and be able to identify situations that need their instant attention with in the firm. Potential investors are lenders used a ratio to determine if they should invest in the company or not. As for stockholders they mainly use this information for forecasting dividends, earnings on the free cash flow.
Case Study: Nike 1. What is the WACC and why is it important to estimate a firm’s cost of capital? What does it represent? Is the WACC set by investors or by managers? The weighted average cost of capital is the maximum rate of return a firm must earn on its investment so that the market value of company's shares will not drop.
1. Cost of Capital Pratt and Grabowski (2010) defined cost of capital is the expected rate of return required by the managers in order to seeking additional funds for a particular investment. It measures the total costs to finance an investment through a combination of debt and equity taking into account different financial risks. There are several reasons why estimating the cost of capital is vital for the management of the company. First of all, cost of capital forces managers to reconsider the capital structure in order to discover the better approach to raise finances.
REAL OPTIONS AND THEIR INCORPORATION WITHIN CAPITAL BUDGETING A real option is a form of derivative, similar to a forward contract, but with a couple of important differences. A real option infers the right, but not an obligation, to buy an underlying real asset. The holder of a real option will compare the market value of the asset in question, along with the agreed exchange value on the option and can then decide whether to exercise that option or tear it up. This flexibility can come at considerable cost, which we will examine in the next section. The process of capital budgeting focuses on the incremental increase in cash flows associated with an investment decision or investment project.
A company's securities typically include both debt and equity, one must therefore calculate both the cost of debt and the cost of equity to determine a company's cost of capital. However, a rate of return larger than the cost of capital is usually required. The cost of debt is relatively simple to calculate, as it is composed of the rate of interest paid. In practice, the interest-rate paid by the company
Key Questions Which of the two methods should Baz emphasize in the client meetings? Should he emphasize one over the other at all? If he didn’t how could he best explain the apparent difference in the results of the two methods? Analysis For more sophisticated analysis, first we decompose the ERP into common and model-specific variables. Common variables include current share price and riskless long-term real yield that are observed in the market.
These are expected returns, standard deviations, correlations of variation, and the capital asset pricing model (CAPM). Expected returns are important to determine if an investment will be beneficial to the investor. Standard deviation is a measure of risk. Correlation of variation is the ratio of risk over expected returns. CAPM is based on the idea that investors consider the time value of money and risk analysis.
1. What is the WACC and why is it important to estimate a firm’s cost of capital? Do you agree with Joanna Cohen’s WACC calculation? Why or why not? * WACC is the weighted average cost of capital.
Finance division evaluates investments using “Weighted Average Cost of Capital” (Wacc) as a hurdle rate to discount the cash flows for an investment opportunity. This Wacc is calculated from two subgroups; cost of equity and cost of debt, giving appropriate weightage to each group. 2. Problem Statement: Following points need to be analyzed; - What risk-free rate and risk premium should be used for cost of equity? - How does the cost of debt for Marriott should be calculated.