For the purpose of calculating the net present value of the project, an appropriate cost of capital has to be calculated at which free cash flows of the project should be discounted. Since the project will be solely financed by selling new shares, cost of equity will be used as the discount rate. Beta for the company can be assumed to be equal to average of the betas of the competitors of the company. This average beta value comes out to be 1.2. Risk free rate is 0.17% while risk premium has been estimated to be 6%. Thus by putting these values in CAPM formula, we can find the cost of equity for the company which is 7.39%.
The cost of equity is the theoretical return that equity investors expect or receive from the company for investing their funds in the company. The risk free rate that is the Government Treasury bill rate is 3.1%, the market risk premium is 7% and the beta has been calculated as
Our estimated cost of capital, 20.81%, is lower than Ricketts’ expected return, 30%-50%, thus the investment is worthy. However, it’s higher than other pessimistic members’ expected return, 10%-15%, making the decision more complex and requiring further valuation。
Currently, Starbucks is considering making an investment in a new manufacturing plant in Augusta, GA. The capital budgeting project requires an initial investment outlay of $ 40 million and is expected to general annual cash flows of 5.200.000, 6.500.000, 8.200.000, 8.700.000, 9.000.000, 9.550.000, and 11.500.000 for years 1 to 7, respectively. Starbucks estimates that the project has a below-average risk and sets the discount rate at 8.06 % -- based on the company’s Weighted Average Cost Of Capital (WACC). The discount rate is effectively the desired return on an investment an
Given these approximations, the CAPM model would total the risk-free rate and the market risk premium times beta to arrive at a cost of equity of 9.68%, which reflects the investors’ expected return from investing in shares of the company.
Star Appliance is looking to expand their product line and is considering three different projects: dishwashers, garbage disposals, and trash compactors. We want to determine which project would be worth doing by determining if they will add value to Star. Thus, the project(s) that will add the most value to Star Appliance will be worth pursuing. The current hurdle rate of 10% should be re-evaluated by finding the weighted average cost of capital (WACC). Then by forecasting the cash flows of each project and discounting them by the WACC to find the net present value, or by solving for the internal rate of return, we should be able to see which projects Star should undertake.
The following case analysis portraits the use of capital asset pricing model to compute the weighted average cost of capital for Marriott and each of its divisions. The flow of events below is following a string of different evaluations, each of which is assessed separately.
Cost of Equity is the return that stockholders require for a company. A company’s cost of equity represents the compensation that the market demands in exchange for owning the assets and bearing the risk of ownership. Based on capital markets the cost of equity varies in direct relation to the assumed risk in that specific market. The distinctive of the firm is the sensitivity to market risk (β) which depends on everything from management to its business and capital structure. Therefore past performances and present conditions have a direct effect on the overall value. Applying calculations at a divisional level allows specified markets to be analysis based on present market conditions for that service or product. The formula used to calculate Cost of Equity is:
Please refer to Appendix 2 for other considerations for cost of equity calculations. Most firms use the Capital Asset Pricing Model (CAPM) to determine the cost of equity. The components that make up the CAPM include: the risk free rate, the beta of the security, and the expected market return of the stock. These values are all based on forward-looking data. The model dictates that shareholders require a return equal to the return from a risk-free investment plus an equity risk premium for bearing extra risk. Refer to Appendix 1 for a full breakdown of the CAPM formula.
WPC has used a discount rate of 15% to evaluate potential projects for the last 10 years. Many in management are correct in thinking that this rate should be evaluated on a much more frequent basis. The current rate of 15% is much too high considering the yield on treasury bonds has declined from 10% to 5% over the last ten years. In order to calculate the correct discount rate we must first determine what their equity and debt ratios are. As you can see in Exhibit1, in order to find the total value of equity we must multiply the number of total outstanding shares of stock times the market value of each share. Completing this calculation shows us that WPC has $12 billion in outstanding equity. WPC also has $2.5 billion in outstanding debt. If you add the debt and equity together we see that WPC has a total of $14.2 billion in outstanding financing. Assuming the 10 year rate of Government Bonds of 4.60% as our risk free rate and using the Capital Asset Pricing Model we find that that WPC’s return on equity is 11.2% (See Exhibit 1). As stated in the case, Worldwide Paper Company has an A bond rating so we can use the 5.78% for their return on debt. Combining all of these variables in the Weighted Average Cost of