WACC Project Instructions 2023 (1)

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Florida Institute of Technology *

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5440

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Finance

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Jan 9, 2024

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WACC Project In this project, the student will find and discern the appropriate data to determine a realistic assessment of the weighted average cost of capital for a firm of his/her choosing. The student will need to search for data from several sources, use subjective judgment to determine which data to use or discard, use subjective judgment to determine which calculation gives a more acceptable estimate and make some simplifying assumptions. The purpose of the projects is to show some of the sources of measurement errors in financial analysis, to introduce the diverse sources of publicly available financial information and to develop skill in analysis in situations where there are too much or too little data. (McDaniel, 1997). When choosing a company, it must be publicly traded, no utilities, no financial firms, no all equity firms, must be paying dividends, and avoid firms with large amounts of convertible securities or warrants. Organization of the paper should be as follows: I. Pages showing equations with data and brief description. Detailed descriptions, tables of data and excel sheets etc will be in the appendix. Cost of Equity (Common Stock) Beta from Regression and two Betas from analysts Beta Chosen for CAPM and why Capital Assets Pricing Model (include how determined R F and[ R M or (R M – R F )] Discounted Cash Flow (DCF) (only if dividends – include how determined growth rate) Own-Bond-Yield-plus-Judgmental-Risk-Premium (include how determine risk premium) Cost of Preferred Stock Cost of Debt (make sure to include table that lists all bond issues with weighted average cost of debt) Market Value of Debt (will have calculated above, but will need to add any long term leases from balance sheet to get total market value of debt) Market Value of Equity Market Value of Preferred Stock Value of Firm

Firm’s Tax Rate (explain how determined) Weight for Equity Weight for Preferred Stock Weight for Debt WACC (Weighted Average Cost of Capital) II. Assumptions: including but not limited to R F , R M, R m - R F. growth rate of dividends. This page should have a brief description of how you came up with the estimates with spreadsheets, etc. to be put in the appendix. III. Appendix Appendix should include all relevant data including debt data from Net Advantage, calculations of weighted average cost of debt, stock returns, betas from analysts, beta regression analysis, method/sourcing for R F and R M, growth rates for dividends, different methods to determine tax rates, etc. IV. References HELPFUL INFORMATION BONDS: I will show you how to access bond yield date in Net Advantage in class. Calculating the Weighted Average Cost of Debt • 1.Find the outstanding amount of each bond issue. 2. Add up all the total of your sample 3. Calculate the weights for each bond issue as Outstanding amount of bond issue/ Total value of sample. Make sure your weights sum to one. 6. For each bond issue, multiply the weight by that issue’s YTM. 7. Sum the weighted YTMs, and you now have the weighted average R D ,

Calculating the Weights for the WACC • 1. Take the book value of bonds (long term debt) from balance sheet. To that you will add in the value of leases as shown on recent statements/ data. • 2. For Preferred Stock, find the number of preferred shares in the annual report and the prices in the WSJ Market Center • 3. For common equity, find the price and number of shares in Yahoo Finance. Calculating the Required Return on Preferred Stock • 1.To Calculate R PF , we use the constant dividend model, ie. the perpetuity model. • 2. R PF = Dividend/P 0 • 3. Check in your company’s annual report to see if they have preferred stock and what the dividend is. Make sure you use the yearly dividend since we are calculating annual returns. • Prices can be found online. Calculating the Required Return on Common Stock CAPM Determining Beta 1. Find the beta from Yahoo Finance and another external source for your firm. 2. Perform a regression using stock returns versus the appropriate market return. For most firms, the S&P 500 will be sufficient; if you chose a relatively small firm, you might want to use the NASDAQ returns. The example that I show you uses IBM and 60 months of historical monthly price data. I also used the monthly price data for the S&P 500. This information is downloaded first and then only the needed columns are cut and pasted into the spreadsheet and the monthly returns will be automatically calculated. Data on stock prices and dividends can be downloaded from the web and used to make betas for real companies. I demonstrate the process for IBM in this section. I downloaded stock prices and dividends from http://finance.yahoo.com for IBM using its ticker symbol IBM. I also downloaded data for the S&P 500 Index, whose symbol is ^GSPC to represent the market. Here are the steps I followed: Steps: 1. Access the Internet, then go to http://finance.yahoo.com/ 2. Enter IBM in the symbol slot and then click Get quotes. 3. Click on "Historical prices" to get a history of IBM prices. 4. Enter a Start Date 5 years ago and a current ending date . Click the "monthly" button. then "Get prices" to get 5 years of monthly prices for IBM. The closing prices are adjusted for dividends and splits. 5. Note that Yahoo's data is downloaded as a CSV file. Save the file as an excel spreadsheet. Save as IBM 6. Repeat the process to get the S&P index, symbol ^GSPC . Save this file as SP500 and in excel format.

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7. Open the IBM file and delete the columns except for the date and closing prices. Then open the SP500 file, copy the closing price data, and paste it into Column B on the IBM file. 8. Now move the IBM data over to column D and then calculate the monthly returns on the market and on IBM 9. Now you can run the regression of IBM's returns on the market to find its beta. Regression analysis is performed by using the ‘SLOPE’ FUNCTION in Excel. Y ou may decide that a years worth of weekly data would be better, perhaps if there were something unusual two years ago. You could also use daily data, generally 200 days worth. In these cases you will have to adjust the spreadsheet for fewer/more data points. 3.You must now decide if you want to average your betas or drop one of them. In our example , the calculated beta was .643 and we had two other estimates of .66 and .85. It would be your choice to either drop the .85 and average the other two, or average all three. You must justify your choices and provide citations/ references at the end. You must now decide what value you will use for R F and either R M or RP M where • CAPM: R E = R RF + (R M – R RF )b = R RF + (RP M )b. Again, You must justify your choices for R F and either R M or R PM and provide citations/ references at the end. The Own-Bond-Yield-Plus-Judgmental-Risk-Premium Method R E = R D + Judgmental risk premium This judgmental-risk premium ¹ the CAPM equity risk premium, R PM . Produces ballpark estimate of RE. Useful check, particularly if Dividend Growth and CAPM are significantly different. Again, you must justify your answer Dividend Growth Model • R E = {[D 0 * (1+g)] /P 0 } + g • The challenge here is to estimate the growth rate. There are several suggestions in your text as well as in earlier videos. Corporate Tax Rate You may be able to find the corporate tax rate directly in the annual report.

Or you can choose to use the formula: Taxes = Tax Rate * Earnings Before Taxes Since both Taxes and Earnings before Taxes are in the Income Statement, you can then calculate the tax rate. Reference McDaniel, William (1997). The Cost of Capital Project Journal of Financial Education , Fall 1997. p. 57-66. OCS DETERMINATION Having approximated your company’s WACC – play around with the percentages of debt and equity to see the impact on WACC. Remember that as the percentage of debt increases, the firm becomes a riskier borrower. Make reasonable adjustments to costs of capital as you vary the capital structure of the firm.