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1 FINANCE FOR EXECUTIVES Managing for Value Creation FINANCE FOR EXECUTIVES Managing for Value Creation Gabriel Hawawini Claude Viallet Gabriel Hawawini Claude Viallet ESTIMATING THE COST OF CAPITAL

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2 EXHIBIT 10.1: Risk and Return for the Sun Cream and Umbrella Investments.

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3 EXHIBIT 10.2: SMC Stock Monthly Returns versus the S&P 500 Monthly Returns.

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4 EXHIBIT 10.3: Beta Coefficients of a Sample of U.S. Stocks. Southwest Air1.60Anheuser-Busch1.00 Texas Instrument1.60McDonald’s1.00 Compaq Computer1.40Walgreen Co.1.00 Whirlpool Corp.1.40Coca-Cola0.95 AMR Corp.1.35Pepsi-Cola0.95 Motorola, Inc.1.30AT&T0.90 Maytag Corp.1.30McGraw-Hill0.85 BancOne Corp.1.25GTE0.80 Abbott Laboratories1.20Bell Atlantic0.80 Air Gas1.20Quaker Oats0.80 Baxter International1.15Ameritech0.75 General Electric1.15Continental Edison0.75 Viacom, Inc.1.10Amoco Corp.0.75 Turner Broadcasting1.10Energy Corp.0.70 Ford Motor Company1.05Texas Utilities0.65 General Motors1.05American Water Works0.65 Source: Value Line Investment Survey, 1996.

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5 AVERAGE RISK PREMIUM TYPE OFAVERAGE ANNUALDIFFERENCE BETWEEN RETURN INVESTMENTRETURNOF INVESTMENT AND RETURN OF Common stocks (S&P 500)12.2%8.5%7.0% Corporate bonds5.7%2.0%0.5% Government bonds5.2%1.5%— Treasury bills3.7%—— EXHIBIT 10.4: Average Annual Rate of Return on Common Stocks, Corporate Bonds, U.S. Government Bonds, and U.S. Treasury Bills, 1926 to 1995. Source: Ibbotson Associates, Inc., 1996 Yearbook. TREASURYGOVERNMENT BILLSBONDS

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6 EXHIBIT 10.5: The Capital Asset Pricing Model.

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7 REUTERSAgency6%7% PEEKElectronics6%7% BRITISH AEROSPACEAerospace6%7% INCHCAPETrading6%7% GLAXO HOLDINGSHealth6%7% LUCAS INDUSTRIESMotor6%7% MARKS & SPENCERStores6%7% BRITISH TELECOMPhone network6%7% SAVOY HOTELSHotels6%7% EXHIBIT 10.6a: Estimation of the Cost of Equity Based on the Capital Asset Pricing Model (CAPM) for a Sample of Companies Listed on the London Stock Exchange (1996). GOVERNMENTMARKET RISK COMPANYINDUSTRYBOND RATEPREMIUM

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8 REUTERS1.736% + (7%)(1.73) = 18.1% PEEK1.52 6% + (7%)(1.52) = 16.6% BRITISH AEROSPACE1.34 6% + (7%)(1.34) = 15.4% INCHCAPE1.30 6% + (7%)(1.30) = 15.1% GLAXO HOLDINGS1.27 6% + (7%)(1.27) = 14.9% LUCAS INDUSTRIES1.21 6% + (7%)(1.21) = 14.5% MARKS & SPENCER0.88 6% + (7%)(0.88) = 12.2% BRITISH TELECOM0.73 6% + (7%)(0.73) = 11.1% SAVOY HOTELS0.40 6% + (7%)(0.40) = 8.8% EXHIBIT 10.6b: Estimation of the Cost of Equity Based on the Capital Asset Pricing Model (CAPM) for a Sample of Companies Listed on the London Stock Exchange (1996). BETAESTIMATED COST OF COMPANYCOEFFICIENTEQUITY WITH THE CAPM

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9 Cash$10,000,000Long-term debt 1 $90,000,000 90,000 bonds at par value $1,000 Working capital$50,000,000 requirement Owners’ equity$90,000,000 2,500,000 shares$25,000,000 at par value $10 Net fixed assets$120,000,000Retained earnings$65,000,000 Total$180,000,000Total$180,000,000 EXHIBIT 10.7: SMC’s Managerial Balance Sheet. INVESTED CAPITAL OR NET ASSETSCAPITAL EMPLOYED 1 SMC has no short-term debt.

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10 EXHIBIT 10.8a: The Estimation of a Firm’s Weighted Average Cost of Capital (WACC), Including an Application to Sunlight Manufacturing Company (SMC). Step 1:Estimate the firm’s relative proportions of debt (D) and equity (E) financing: DEE + D STEPS TO FOLLOWHOW TO and Use the firm’s market values of debt and equity. The market value of debt is computed from data on outstanding bonds using the bond valuation formula (equation 10.1). The market value of equity is the share price times the number of shares outstanding. If the firm’s securities are not publicly traded use the market value rations of proxy firms.

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11 EXHIBIT 10.8b: The Estimation of a Firm’s Weighted Average Cost of Capital (WACC), Including an Application to Sunlight Manufacturing Company (SMC). Step 2:Estimate the firm’s aftertax cost of debt: k D (1 – T c ). STEPS TO FOLLOWHOW TO If the firm has outstanding bonds that are publicly traded, use equation 10.1 to estimate k D. Otherwise, use the credit spread equation (equation 10.2) or ask the bank. Use the marginal corporate tax rate for T c.

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12 EXHIBIT 10.8c: The Estimation of a Firm’s Weighted Average Cost of Capital (WACC), Including an Application to Sunlight Manufacturing Company (SMC). Step 3:Estimate the firm’s cost of equity: K E. STEPS TO FOLLOWHOW TO Use the capital asset pricing model (equation 10.11). The risk-free rate is the rate on government bonds. The market risk premium is 7% (historical average). Use the beta of the firm’s stock. If the firm’s shares are not publicly traded, estimate beta from proxies. Step 4:Calculate the firm’s weighted average cost of capital (WACC). WACC = k D (1 – T c ) + K E D E + D E E + D

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13 McDonalds1.010.170.92 Wendy’s International0.920.230.81 CKE Restaurants1.150.221.02 Average values1.030.210.92 EXHIBIT 10.9a: Proxies for Buddy’s Restaurants. EQUITYDEBT-TO-EQUITY RATIO 1,2 ASSET BETA 1 DBETA 3 E At market value 1 Data from Alcar, June 1996. 2 D = debt; E = equity. 3 Calculated according to equation 10.7 with a corporate tax rate of 40 percent.

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14 McDonalds0.140.410.860.59 Wendy’s International0.190.360.810.64 CKE Restaurants0.180.470.820.53 Average values0.170.410.830.59 EXHIBIT 10.9b: Proxies for Buddy’s Restaurants. DEBT RATIO 1,2 EQUITY RATIO 1,2 DEE + D At market valueAt book valueAt market valueAt book value 1 Data from Alcar, June 1996. 2 D = debt; E = equity. 3 Calculated according to equation 10.7 with a corporate tax rate of 40 percent.

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15 EXHIBIT 10.10a: The Estimation of a Project’s Cost of Capital when the Project Risk Is Different from the Risk of the Firm, Including an Application to the Buddy’s Restaurants Project. Step 1:Estimate the project’s relative proportions of debt (D) and equity (E) financing: DEE + D using proxy firms. STEPS TO FOLLOWHOW TO and Use the proxies’ market values of debt and equity. The market value of debt is computed from data on outstanding bonds using the bond valuation formula (equation 10.1). The market value of equity is the share price times the number of shares outstanding. Take the mean of the proxies’ ratios.

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16 EXHIBIT 10.10b: The Estimation of a Project’s Cost of Capital when the Project Risk Is Different from the Risk of the Firm, Including an Application to the Buddy’s Restaurants Project. Step 2:Estimate the project’s aftertax cost of debt: k D (1 – T c ). STEPS TO FOLLOWHOW TO If the proxies have outstanding bonds that are publicly traded, use equation 10.1 to estimate their cost of debt k D. Otherwise, use the credit spread equation (equation 10.2) or ask the bank. Take the mean of the proxies’ cost of debt. Use the marginal corporate tax rate for T c.

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17 EXHIBIT 10.10c: The Estimation of a Project’s Cost of Capital when the Project Risk Is Different from the Risk of the Firm, Including an Application to the Buddy’s Restaurants Project. Step 3:Estimate the project’s cost of equity: k E. STEPS TO FOLLOWHOW TO Use the capital asset pricing model (equation 10.11). The risk-free rate is the rate on government bonds. The market risk premium is 7% (historical average). Un-lever the proxies’ equity betas using equation 10.7 to get their unlevered asset betas. Re-lever the mean of the proxies’ asset betas at the project’s target debt-to-equity ratio using equation 10.6 to get the project’s equity beta. Apply the CAPM to the project’s equity beta to get the project’s cost of equity k E.

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18 EXHIBIT 10.10d: The Estimation of a Project’s Cost of Capital when the Project Risk Is Different from the Risk of the Firm, Including an Application to the Buddy’s Restaurants Project. STEPS TO FOLLOWHOW TO Step 4:Calculate the project’s weighted average cost of capital (WACC). WACC = k D (1 – T c ) + K E E E + D D E + D

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19 EXHIBIT 10.11: Company-Wide Cost of Capital and Projects’ Expected Rates of Return.

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