Module 3 – SLP
Capital Budgeting and the Cost of Capital
For your Module 3 SLP assignment,
continue to do research on the company that you wrote about for Modules 1 and
2. For this assignment, you will be estimating the weighted average cost of
capital (WACC) for your chosen company. The final calculation will be fairly
straightforward, as it involves just plugging in some numbers into an equation.
However, the more challenging task will be finding the necessary numbers to
plug into the formulas. You will need information such as the beta for your
company, the bond-rating, and various information from its balance sheet. Links
to some suggested Web pages for finding this kind of information is included in
the instructions, but you might be able to find other sources of information.
Go step by step and present your information for Steps 1-4 below in a Word
document. Make sure to show all of your steps one by one and include the
sources of your information:
- Find out your chosen company’s credit
rating. Rating agencies such as Moody’s and Standard and Poor’s assign ratings
to companies. AAA is high, AA is lower, BBB is even lower, etc. The higher
the rating, the lower the cost of debt capital. Explain what your
company’s credit rating is and the reasons for the high or low rating
based on your research. Also, use the Fidelity
Fixed Income Web page to find out what the current return is for a
30-year bond for a corporation with the rating that your company has. This
yield will be the approximate cost of debt capital for your company. We
will call the cost of debt RD.
- Now estimate the cost of equity for your
company. First you will need the beta; you already found this for your
Module 1 SLP. You will also need the three-month treasury bill yield,
which we will use as our measure of the risk-free rate. This rate should
be listed on the Fidelity Fixed Income Web page linked above. Finally, you
will need the equity risk premium. You can find estimates of this on many
Web pages including Fidelity
Fixed Income or Gutenberg Research. It is usually around 5%. Once you
have this information, you can estimate the cost of equity as the 30-year
treasury bill yield rate plus beta multiplied by the equity premium:
Cost of Equity = risk-free rate + Beta * (Equity Premium).
Show your calculations. We will call the cost of equity RE.
- Now find out how much of the firm’s
capital is equity and how much is debt. For the total value, look at the
balance sheet for your company as found on Google Finance or a similar Web
page. The total value of your company will be “total liabilities and
shareholder’s equity.” The proportion of debt will be total liabilities
divided by total value, which we will call D/V. The proportion of equity
will be shareholder’s equity divided by total value, or E/V. If you
calculate them correctly, the proportions will add up to one.
- Now we have all the information we need to
get at least a rough ballpark estimate of WACC. Let’s assume a corporate
tax rate of 35%. So the formula we will use is WACC = (E/V)* RE +(D/V)* RD *(1-.35)
Calculate WACC and show your computations. As a “reality check” on your
calculations, the WACC should likely be in the single digits and positive.
Compare what you found to the average WACC in your company’s industry,
which should be available on Web pages such as Cost of Capital by Sector (US). Note that 35% is the
official corporate tax rate, but many corporations find tax breaks. If
your WACC is too low, try computing it with a lower tax rate such as 25%
SLP Assignment Expectations
- Answer the assignment questions directly.
- Stay focused on the precise assignment
questions. Do not go off on tangents or devote a lot of space to
summarizing general background materials.
- For computational problems, make sure to
show your work and explain your steps.
- For short answer/short essay questions,
make sure to reference your sources of information with both a
bibliography and in-text citations. See the Student Guide to Writing a High-Quality Academic Paper,
including pages 11-14 on in-text citations. Another resource is the
“Writing Style Guide,” which is found under “My Resources” in the TLC
Module 3 – Background
Capital Budgeting and the Cost of Capital
Start off the module by viewing
these videos from Professor Roberts of the Wharton School of Business at the
University of Pennsylvania and Professor Roberts of Rice University. These
videos will give you a general overview of the key concepts of capital
budgeting and the cost of capital:
M. (2017). Decision criteria. Coursera. Retrieved from: https://zh.coursera.org/learn/wharton-finance/lect…
Weston, J. (2017) Putting it all
together as WACC (weighted average cost of capital). Coursera. Retrieved from: https://www.coursera.org/learn/finance-for-non-fin…
S., Westerfield, R., & Jordan, B. (2007) Chapter 8: Net present value and
other investment criteria. Essentials of Corporate Finance.
McGraw Hill. http://novellaqalive2.mheducation.com/sites/dl/fre…
[If the link is down, click Net Present Value or Fundamentals of Corporate Finance for an alternative link]
S., Westerfield, R., & Jordan, B. (2007) Chapter 12: Cost of capital. Essentials
of Corporate Finance. McGraw Hill. Retrieved from: http://novellaqalive2.mheducation.com/sites/dl/fre…
[If the link is down, click Cost of Capital or Fundamentals of Corporate Finance for an alternative link]
Finally, check out the following
video that will show you how to make capital budgeting calculations using
Graulich, V. (2012). How to
calculate NPV and IRR. IHateMath.com. Retrieved from:
Hamilton, K. (2014). Excel NPV
IRR. Retrieved from:
If you still have difficulty with
the material after reviewing the required materials, check out the optional materials
below. Included are two additional videos, including one on using Excel to
compute NPV and IRR. Also included are some additional book chapters that cover
the same material but explain it in a slightly different way with different
Learn it FAST: Weighted average cost of capital explained. Retrieved from:
Girvin, M. (2010). Investment
criteria: NPV, IRR, payback, AAR, profitability index. Retrieved from:
Fabozzi, F. J., & Peterson
Drake, P. (2009). Chapter 14: Capital budgeting techniques. Finance:
Capital markets, financial management, and investment management.
Wiley. Available in the Trident Online Library.
Clive, M. (2012). Chapter 14: The
cost of capital. Financial management for non-financial managers. Kogan
Page. Available in the Trident Online Library.
Block, S. & Hirt, G. (2008).
Chapter 12: The capital budgeting decision. Foundations of Financial
Management. McGraw-Hill, Retrieved from: http://studylib.net/doc/8149455/12-the-capital-bud…