The problems to estimate the cost of capital

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

While this may be a fair assumption depending on what the Bidding Group is comfortable with, there was a wide range used to make the beta estimates. This beta estimate will have the biggest impact on return because of the effect it has on pricing Hertz’ assets.

The formula is: βA=DD+EβD+ED+EβE. From Exhibit 4, we find discount brokerage companies less relied on debt. Thus βD’s effect is small and we assume βD = 0. Here we use the current Debt/Value, since market value is more accurate.

Capital is the source of fiancé through which resources are provided. It may be debt financing

Debt capital: borrowing someone else’s money to finance the business under the condition that the money plus accrued interest must be paid back in full by an agreed upon date in the future

Cost of capital is what it will cost the firm, on the margin, today, to secure its financial resources for further growth.

The mixture of debt-equity mix is important so as to maximize the stock price of the Costco. However, it will be significant to consider the Weighted Average Cost of Capital (WACC) as well so that it can evaluate the company targeted capital structure. Cost of capital (OC) may be used by the companies as for long term decision making, so industries that faced to take the important of Cost of capital seriously may not make the right choice by choosing the right project(Gitman’s, ).

* We assume the cost of capital to be a stated annual rate to facilitate calculations;

A common practice to determine the firm’s beta is to draw from historical data from published sources or compare numbers to competitors. In this case, Heinz can compare to Kraft, Campbell Soup and Del Monte and use professional judgement in determining the stock’s sensitivity to the market. A stock’s beta can be determined using a formula as well.

3) What is the weighted average cost of capital and why is it important to estimate it? Is the

Kd (Wd), Ke (We) and Kp (Wp) are the costs (weights) associated, respectively, with the firm’s interest bearing debt,

Despite this change in price, the Weighted Average Cost of Capital (WACC) will give a more accurate representation of what the change in capital structure implies for the firm, by taking account the costs of debt.

For estimation of betas, the above equation was run for the period from Jan, 2003 to Dec, 2006. Based on the estimated betas we have divided the sample of 63 stocks into 10 portfolios each comprising of 6 stocks except portfolio no.1, 5 and 10 having seven stocks each. The first portfolio 1 has the 7 lowest beta stocks and the last portfolio 10 has the 7 highest beta stocks. The rationale for forming portfolios is to reduce measurement error in the betas.

Even though there are flaws in the CAPM for empirical study, the approach of the linearity of expected return and risk is readily relevant. As Fama & French (2004:20) stated “… Markowitz’s portfolio model … is nevertheless a theoretical tour de force.” It could be seen that the study of this paper may possibly justify Fama & French’s study that stated the CAPM is insufficient in interpreting the expected return with respect to risk. This is due to the failure of considering the other market factors that would affect the stock price.

This case study focuses on where financial theory ends and practical application of the weighted average cost of capital (WACC) begins. It presents evidence on how some of the most financially complex companies and financial advisors estimated capital costs and focuses on the gaps found between theory and application. The approach taken in the paper differed from their predecessors in several various respects. Prior published information was solely based on written, closed-end surveys sent to a large number of firms, without a focused topic. The study set out to see if financial theory, specifically cost-of-capital, is truly ubiquitous in true business applications.