Scribd
Upload
78 views

SABV Topic 4 Questions

This document discusses several topics related to weighted average cost of capital (WACC): 1) It discusses using divisional WACCs to avoid over- or under-investing in divisions based on risk levels. 2) It asks how a project with an IRR lower than the corporate WACC could have a positive NPV. 3) It discusses whether discount rates or cash flows should be adjusted to account for overly optimistic forecasts in emerging markets. 4) It provides an example of calculating a firm's WACC and discusses how a project WACC would differ using different leverage assumptions.

Uploaded by

Ngoc Hoang Ngan Ngo
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
78 views

SABV Topic 4 Questions

This document discusses several topics related to weighted average cost of capital (WACC): 1) It discusses using divisional WACCs to avoid over- or under-investing in divisions based on risk levels. 2) It asks how a project with an IRR lower than the corporate WACC could have a positive NPV. 3) It discusses whether discount rates or cash flows should be adjusted to account for overly optimistic forecasts in emerging markets. 4) It provides an example of calculating a firm's WACC and discusses how a project WACC would differ using different leverage assumptions.

Uploaded by

Ngoc Hoang Ngan Ngo
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
You are on page 1/ 2

5.1.

THOUGHT CUESTION Explain how a firm might use the divisional WACC
approach to avoid overinvesting in divisions with more risky projects and underinvesting in
divisions with less risky projects.

5.2. THOUGHT QUESTION Mango Services Company has a corporate WACC of 10%.
You propose investing in a new project that has very little risk with an internal rate of return
(IRR) of 8%. Your boss asks "How can the project possibly have a positive NPV if its IRR is
less than our WACC?" What is your answer?

5.3. INVESTOR OPTIMISM AND THE COST OF CAPITAL Investment projects located in
Indonesia and other emerging markets frequently have low systematic risk, implying that the
appropriate discount rates for the projects are quite low. In practice, most firms (with some
notable exceptions) use very high discount rates for these projects. One explanation that has
been offered for this practice is that the investing firm uses the high discount rates in an
attempt to offset the effects of optimistic cash flow estimates. Is it a good idea to adjust for
the risk of overly optimistic cash flow forecasts using changes in discount rates, or should the
cash flows themselves be adjusted?

5.4. CALCULATING A FIRM’S WACC AND PROJECT WACC Amgel Manufacturing


Company’s current capital structure is comprised of 30% debt and 70% equity (based on
market values). Amgel’s equity beta (based on its current level of debt financing) is 1.20, and
its debt beta is 0.29. Also, the risk-free rate of interest is currently 4.5% on long-term govern-
ment bonds. Amgel’s investment banker advised the firm that, according to her estimates, the
market risk premium is 5.25%.

a. What is your estimate of the cost of equity capital for Amgel (based on the CAPM)?
(Answer: 10.80% - Using CAPM)
b. If Amgel’s marginal tax rate is 35% and cost of debt is 6%, what is the firm’s overall
weighted average cost of capital (WACC)? (Answer: 8.73%)
c. Amgel is considering a major expansion of its current business operations. The firm’s
Investment banker estimates that Amgel will be able to borrow up to 40% of the needed
funds and maintain its current credit rating and borrowing cost. Estimate the WACC for this
project.
 Notes: Borrow up to 40% of the needed funds  Wd = 40%, We = 1 – 40%
 Calculate beta leverage of the firm by un-leveraging and then re-leveraging.
 Beta_unleverage = (beta leverage + debt beta * D/E)/(1+D/E) = 0.927
 Re-leverage: 0.927(1 + 0.4/0.6) – debt beta (0.4/0.6) = 1.35
 Calculate Re using CAPM (11.6%)  Calculate WACC

5.5. CONCEPTUAL EXERCISE The term hurdle rate is often used in the context of project
evaluation and is sometimes used to refer to the risk-adjusted discount rate—i.e., the required
rate of return on a project with a given level of risk. The risk-adjusted discount rate refers to
the cost of capital or opportunity cost of raising money to finance an investment, and hurdle
rates are generally higher than the cost of capital. Why might a firm use hurdle rates that
exceed its cost of capital?
5.9. PROJECT WACC USING CORPORATE FINANCING In the fall of 2014, Pearson
Electronics, which manufactures printed circuit boards used in a wide variety of applications
ranging from automobiles to washing machines, was considering whether or not to invest in
two major projects. The first was a new fabricating plant in Omaha, Nebraska, which would
replace a smaller operation in Charleston, South Carolina. The plant would cost $50 million
to build and incorporate the most modern fabricating and assembly equipment available. The
alternative investment involved expanding the old Charleston plant so that it could match the
capacity of the Omaha plant and modernizing some of the handling equipment at a cost of
$30 million. Given the location of the Charleston plant, however, it would not be possible to
completely modernize the plant due to space limitations. The end result, then, is that the
Charleston modernization alternative cannot match the out-of-pocket operating costs per unit
of the fully modernized Omaha alternative.

Pearson’s senior financial analyst, Shirley Davies, made extensive forecasts of the cash flows
for both alternatives but was puzzling over what discount rate or rates she should use to
evaluate them. The firm’s WACC was estimated to be 9.12%, based on an estimated cost of
equity capital of 12% and an after-tax cost of debt capital of 4.8%. However, this calculation
reflected a debt to value ratio of 40% for the firm, which she felt was unrealistic for the two
plant investments. In fact, conversations with the firm’s investment banker indicated that
Pearson might be able to borrow as much as $12 million to finance the new plant in Omaha
but no more than $5 million to fund the modernization and expansion of the Charleston plant
without jeopardizing the firm’s current debt rating. Although it was not completely clear what
was driving the differences in the borrowing capacities of the two plants, Shirley suspected
that a major factor was the fact that the Omaha plant was more cost effective and offered the
prospect of much higher cash flows.

a. Assuming that the investment banker is correct, use book value weights to estimate the
project-specific costs of capital for the two projects. (Hint: The only difference in the WACC
calculations relates to the debt capacities for the two projects.)

b. How would your analysis of the project-specific WACCs be affected if Pearson’s CEO
decided to deliver the firm by using equity to finance the better of the two alternatives (i.e.,
the new Omaha plant or the Charleston plant expansion)?

You might also like