Value Based Management and Capital Budgeting Analysis

Estimate the cost of capital for financing (Hint: Interest expense and total debt – Ascertain the return on equity to provide measures for the interest rate and the return to stockholders.

What is the correct capital structure and weighted average cost of capital for discounting the investment’s free cash flow?

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

Assumptions need to be made for the Cost of Equity. We used the corporate rate of 11.766%

We use Capital Asset Pricing Model (CAPM) approach to calculate the cost of equity. The formula of CAPM is re = rf + β × (E[RMkt] – rf).

What are some alternative ways to obtain a market risk premium for use in a CAPM cost-of-equity calculation? Discuss both the possibility of obtaining estimates from outside organizations and also ways which Ace could calculate a market risk premium itself.

Cost of Equity = Risk free rate + (Market return – risk free rate) X beta

To find the cost of equity we used the formula rs = rRF + beta*MRP in which rRF2002 = 5.86% and the Market Risk Premium (MRP) = 5% as calculated by the Southwest Airlines finance department. We then calculated the beta for Southwest Airlines based on a regression analysis of five-year monthly returns on Southwest stock from January 1997 to January 2002, compared with the S&P 500 returns over the same period. This regression analysis indicated that Beta = .2219. Therefore,

a. What risk-free rate and risk premium did you use in calculating the cost of equity for each division? Why did you choose these numbers?

Risk free rate + Equity Beta * (Expected return on market - Risk free rate)

Solutions to Valuation Questions 1. Assume you expect a company’s net income to remain stable at $1,100 for all future years, and you expect all earnings to be distributed to stockholders at the end of each year, so that common equity also remains stable for all future years (assumes clean surplus). Also, assume the company’s β = 1.5, the market risk premium is 4% and the 20-30 year yield on risk free treasury bonds is 5%. Finally, assume the company has 1,000 shares of common stock outstanding. a. Use the CAPM to estimate the company’s equity cost of capital. • re = RF + β * (RM – RF) = 0.05 + 1.5 * 0.04 = 11% b. Compute the expected net distributions to stockholders for each future year. • D = NI – ΔCE = $1,100 – 0 = $1,100 c. Use the

Taking the CAPM equation, we were able to figure out eh cost of equity and in its credit range

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:

Thus the cost of capital can be easily calculated using the weighted average cost of capital formula (13.69%).

1a. Please use the capital asset pricing model to estimate the cost of equity. At the date of the case, the 74 over T-bonds. Which beta, risk-free rate, and risk premium did you use? Why? Financing Components Debt Equity Market Values Weight Cost of Capital (After Tax) $ 6,823,736,197 0.85 3.72% $ 1,176,263,803 0.15 28.18% Total: $ 8,000,000,000 1.00 WACC WACC Inputs: Beta: Risk-Free Rate: Market Risk Premium: Pre-tax Cost of Debt: Income Tax Rate: