Finance and Capital Budgeting - Assignment Example

Finance Capital Budgeting Question Some Over-Riding Conceptual Issues a) Western can use the cost of capital estimate as a benchmark of the minimum returns required on the capital employed in the business. Western could also use it to determine the minimum return required on a particular project. However, it cannot be used for specific projects because each project has it own operating risk. b) Book weights should be used to calculate WACC because the market value is subjective and changes regularly. c) Current (marginal) cost rates should be used because WACC is used mainly to make investment decisions and these decisions depend on expected future cash flow from projects in relation to the cost of new capital. d) A separate WACC should be calculated based on the project and the costs of the different components of capital and the percentage of each component of capital that is used. Therefore, different weights would be used based on the weights expected to be used for the relevant project Question 2 – Component Cost of Preferred stock a) Western can deduct interest on its debt while there are no similar deductions for dividends. This is so because interest is allowable as a deduction for tax purposes while dividends on common or preferred stocks are not allowable as deductions for tax purposes. b) Given the difference in bond ratings between the utility subsidiaries and the unregulated subsidiary the various units have different costs of preferred stock. The one with the higher bond rating would have the lower cost and the one with the lower bond rating the highest cost. The utility subsidiaries and the unregulated subsidiaries would have different levels of operating risks c) The value at close should be used or the average of the highest and the lowest bid.. Question 3 – Component Cost of Common Equity a) The methods that might be used to estimate the cost of common equity are: the capital asset pricing model (CAPM); the discounted cash flow (DCF) method; and the bond-yield-plus-risk-premium approach. i. T-bills are short-term securities and the rate on them varies over time and so provides a volatile earnings stream. T-bonds are long-term securities and the rates are less volatile. Since common stocks are long term securities even though not all stockholders have a long term horizon, most invest for the long term. Stock returns reflect long term inflation, similar to those reflected in bonds rather than the short-term expectations reflected in treasury bills. Theoretically, the CAPM measures the expected return over a period. This period is the life of the project. The rate on a long term T-bond is therefore a logical choice since many projects have long lives. ii. Alternative ways of estimating the market risk premium are by the use of historical data; and forward-looking data. iii. Betas are the amount of risk that the stocks contribute to the market portfolio. The tendency of a stock to move up and down is reflected in its beta coefficient. They affect cost of equity estimates. If the beta coefficient is positive then it means that the relationship between the stock return and the marker return is positive and therefore varies with the market. A figure less than 1 suggests risks, 1 suggests the market average and greater than 1 very risky. iv. Growth rates for the use of DCF cost of equity studies are estimated by using: historical growth rates; the retention growth model; and analyst’s forecasts. v. In order to estimate the risk premium over Western’s own bond rate and to arrive at an estimate for its common stock one would do the following. Simply add a judgemental risk premium of approximately 3 to 5 percentage points to the interest rate on the long term debt relating to the firm. The logic of basing the cost of equity on a readily observable cost of debt is based on the fact that firms that have risky, low ratings and as a result high interest rate debt will also have a high cost of equity. Using this approach: rs = Bond yield + Bond risk premium, where rs is the return on common stock. b) If Western had earned an average return on equity (ROE) of 14% over the last few years and paid out 75% of its net income as dividends then this information can be used to estimate the firm’s expected growth rate (g). g = ROE (Retention ratio) If payout = 75% then retention rate is 25%. Therefore g = 0.14 x 0.25 = 0.035 which is equal to 3.5%. Therefore, ks = (D1/P0) + g = ($1.22/$20 ) + 0.35 = 0.096 = 9.6% c) The cost of equity to the company is identical to the required rate of return and the expected rate of return to the marginal investor if the market is in equilibrium. It matters whether the equity whose cost is being estimated comes from retained earnings or from issuing common stock because issuing more shares results in dilution of earnings which results in a reduction in earning per share. d) The estimate of Western’s cost of equity as determined T-bond risk free rate for both earnings and new equity raised by issuing stock is: ROE using retained earnings and from issuing new common stock Question 4 – Weights for the WACC Calculation Using the information given in the case and in Table 4 the weights that should be used to calculate Western’s WACC is 45% for debt, 50% for common equity and 5% preferred stock. The same weights should not be used for all subsidiaries and for all projects within a subsidiary. It depends on the proportions that will actually come from those sources to fund the desired project. The weights that should be used are based on the book values of the proportions of the different forms of long-term capital in the structure. The proportions are 44.1% Long Term Debt, 8.3% Preferred Stock and 47.6%, equity capital. How much difference the weights make depends on the cost of these instruments. Based on my calculations debt now has a slightly less weight than the 45% that Western calculated, preferred stock has a much higher proportion and equity capital also has less. If the cost of debt is higher then their will be reduction in WACC since its weight is now a little less than before and more of a lower cost capital such as preferred stock has been substituted. If on the other had the cost of debt is less than the cost of equity capital and preferred stock, than that will increase WACC because more of the higher cost capital is used and less lower cost capital. Question 5 - Internal versus External Capital a) The cost of funds provided by depreciation is the weighted cost of the funds used to acquire the assets that the depreciation charge relates to. Different assets would have been financed under different projects. Some might have been acquired with the use of equity capital only, some debt only and some preferred stock only. It is the historical costs that were used at acquisition that would apply. They would also have been purchased at different times and one also has to bear in mind that some of the assets have been fully depreciated and should not be therefore be considered as part of the cost of capital. b) . c) If depreciation was simply ignored this could affect the capital expenditure decision because depreciation is an expense that does not involve an outflow of cash. Question 6 - Marginal Cost of Capital Question 7 - Cost of Capital for Different Purposes a) The same WACC should be used for regulatory purposes, for internal decisions such as capital expenditures, and for EVA. The three subsidiaries should use different WACCs because their capital structure is not the same and the cost of debt is different and is based on the rating provided by rating agencies such as Moody’s and S&P. Additionally, their risk beta coefficients are different. b) The project specific WACC should be used for capital budgeting purposes. It would matter if the decision pertained to a capital expenditure related to a generating plant versus the distribution system because each project has a different risk characteristics. The distribution system is less risky than the generating plant. The nature of the plant suggests a riskier venture which therefore comes with higher cost of capital to allow for the higher risk involved. Additionally competition is least likely to develop in the distribution system and therefore the returns are likely to be higher. If the project is related to a utility or to the unregulated subsidiary it would matter because the risk is higher for the unregulated subsidiary and there are no specific requirements set out for them to conform to as exists for the utility. c) If a rate case was being heard at a time when the yield curve was upward sloping, the consumer witness (who would want to report a low cost of capital so as to reduce the required level of profits, hence customers’ bills) who used the CAPM to estimate the cost of common equity would be more likely to use the T-bills as the risk free rate because it is a short-term security and the returns are volatile. Question 8 – Using the Cost of Capital in Capital Budgeting I would use the highest rate of return of 11.65% in the table because the project has the longest time period in which to recover its cost and the longer the time period the more risky the project. So even though we assume they are equally risky there is a difference in terms of the period. Secondly, I am uncertain as to whether this is a unregulated investment programme or a new generation plant so to be safe I would use a rate of return that is higher than 11.65%. Question 9 – Large Merger If Western is thinking about merging with another utility, one that is almost as large as Western and which is comparable to Western in many respects but it has financial difficulties. Its bonds are rated BB, and its beta coefficient is 1.1 versus Western’s beta of 0.65. This acquisition will affect the consolidated company’s cost of capital but not the cost of capital for Western’s current three subsidiaries. This can be handled by taking steps to address the factors that affect the bond rating and the higher risk beta coefficient. Western could make changes to the company’s capital structure and other underlying ratio that affect the higher risk factor associated with the second company. The second company’s fundamental beta can be calculated as it incorporates information about the company, such as changes in its product lines and capital structure. Reference Brigham, E.F. and Ehrhardt, M.C. (2005). Financial Management: Theory and Practice. 11th ed. USA: Thomson South-Western. Read More