Schweser question : WACC 2005, pro, maintain, question, understand

tarik64

Happy Friday everyone....a little confused on the below....The question asks to calculate the WACC, however I dont understand how to differentiate between the details of the two questions.


The question says:

Before evaluating the projects, Conover must make some pro forma forecasts for 2005. According to Bailey’s 2005 pro forma income statement, Conover expects Bailey to earn a net profit of $7,000. He also expects the firm to maintain its current dividend payout ratio of 50%. The firm has a target capital structure of 70% equity and 30% debt. Conover estimates the applicable corporate tax rate to be 35%.

Conover’s next step is to evaluate capital market conditions. Because Bailey is in an economically sensitive industry, the firm has a greater than average level of systematic risk. Conover estimates that the beta applicable for a standard project for the firm is 1.5. Over the last three years, the U.S. economy has been in a sustained expansion, and Bailey has enjoyed strong profit growth. This strong growth has allowed Bailey to fund most of its capital budget internally. However, many economists believe that growth will slow in 2005 despite the government’s accommodative fiscal policy. As a result, Conover believes that management’s aggressive goals and objectives imply that Bailey will need to seek external capital.

Conover calls a meeting with Derek Munn, CFA, an investment banker with Lyndon Capital Corp. Using Conover’s forecasts, Munn believes that Bailey will be able to issue new debt at a cost of 9% and new equity at a cost of 18%. Munn also gives Conover a research report that says the 2005 expected return for the market is 11%, and three-month Treasury bills will yield 5%.

1) Conover starts his analysis by estimating the firm’s current weighted average cost of capital (WACC). What is the firm’s current WACC?

2)Conover calculates new WACC beyond the retained earnings break-even point as:







Answers:

1) 11.56%
2)14.36%

burnsy562000

this was a great help! thanks!!

Bluetick1010

That really helps..now i get why we can't use 18% in the first question..but why can we use the cost of issuing new debt, which is 9%, in the first question? I couldn't find any clue suggesting that our cost of issuing debt remain constant. THX!!

ajpheif16

debt has a fixed rate, say 9% a year, when investors buy debt, they know they are getting 9% more back and the issuer knows it will have to pay 9% more. whereas equity doesnt give you a return rate, investors dont know what they are getting back when they purchase equity. CAPM gives you the expected return on equity using current value, this is also the cost of equity for issuer in the form of dividend and incresing in stock value. This can change year over year,so Ke is mark to market.

kd26gioi

WACC measures the cost oppurtunity a firm forgo to invest capital in its project, this is usually retrospective. so when you calculate it, you are using the current/cumulative data for the capital is raised internally from Bailey's own fund. If Baileys were to raise equity from the market in the future, WACC would be different because 14% ke is the oppurtunity cost of baileys own fund, where 18% ke is the cost of capital paid out to new equity owners.

lc26mizzou

don't understand either..I also think 18% cost of equity can be used directly..can anyone explain this?

smartpants

that kind of helps.....I understand "beyond retained earnings..."

But again, question one is not completely clear.

Here's my train of thought:

The question reads "Munn believes that Bailey will be able to issue new debt at a cost of 9% and new equity at a cost of 18%."

Yes, I understand that the CAPM asks for expected market return. But in calculating the WACC for q1, we use the 9% cost of debt (as stated in the sentence)...so accordingly, I'd assume we'll also use the 18% cost of equity in WACC? I'm sorry for being repetitive, but I'm a having a mind block here :/

Thanks for all the help!

manasib

You wouldn't use 18% for the first part because CAPM asks for expected return on market, which is stated at 11%.

Since it is stated that the cost to raise equity for the firm is 18%, this goes into the WACC. Still not sure about the "beyond retained earnings break even point".

Hope this helps.

Flok

1) ke = .05 + 1.5(.11-.05) = .14 (CAPM)
WACC = (.3)(.09)(1-.35) + (.14)(.7) = 11.56%
Wd kd (1-t) ke We
2) ke = .18 (given in last paragraph of question)
WACC = (.3)(.09)(1-.35) + (.18)(.7) = 14.36%

The only thing that changes is the cost of equity, since the capital structure stays the same (70% equity 30% debt). I'm hoping that is all you wanted to know because I can't really give you a better explanation why.