Fina 301 financial analysis exercise iv

Financial Analysis Exercise IV

Part A: Weighted Average Cost of Capital (WACC)

Here again is the formula for WACC. For simplicity the term for preferred stock has been removed:

1.   Go to http://thatswacc.com/[1] and enter the ticker symbol for the stock you selected and click on the tab entitled “Calculate WACC.”

2.   Complete the following table:

 Name of Company/Stock Ticker Symbol WACC Cost of debt, iD Corporate tax rate, TC Total debt, D Total equity, E Total value of the firm, V Beta, β Return on the market, iM Assumed 11% Risk-free rate, iF Assumed 3%

1. Using data in the table confirm the accuracy of the site’s WACC calculation:

 E D D · (1- TC) WACC =  · iE +  · iD · (1-Tc)

Part B: Dividend Payout and Growth Ratios

Recall from Module 1 the following two ratios:

Internal growth rate = (ROA ∙ RR) / [1-(ROA ∙ RR)]                                       (Eq. 3-30)

where RR = Retention ratio = (Addition to retained earnings)/Net income                     (Eq. 3-31)

The internal growth rate measures the amount of growth a firm can sustain if it uses only internal financing (retained earnings) to increase assets

Sustainable growth rate = (ROE ∙ RR) / [1-(ROE ∙ RR)]                                 (Eq. 3-33)

If the firm uses retained earnings to support asset growth, the firm’s capital structure will change over time, i.e., the share of equity will increase relative to debt

To maintain the same capital structure managers must use both debt and equity financing to support asset growth

The sustainable growth rate measures the amount of growth a firm can achieve using internal equity and maintaining a constant debt ratio

1. For the firm selected for Part A, calculate its internal growth rate for the last fiscal year:

 =  (ROA ∙ RR) / [1-(ROA ∙ RR)]        =

2. Calculate the firm’s sustainable growth rate for the last fiscal year:

 =  (ROE ∙ RR) / [1-(ROE ∙ RR)] =

Part C.

1.      Consider your results for Parts A and B. If the chosen firm grows at its internal growth rate, increasing assets only with its retained earnings, how will this likely affect its WACC? Show calculations.

2.      If the chosen firm grows at its sustainable growth rate with increases in both its retained earnings and debt, maintaining a constant debt ratio, how will this affect its WACC?

3.      If the chosen firm attempts to grow faster than its sustainable growth rate with modest increases in its debt ratio, how will this likely affect its WACC? What about very large increases in its debt ratio? Explain.

Appendix

Should the Web site http://thatswacc.com/ not be available, please follow the instructions below that have been posted at http://thatswacc.com/faccs.php on how to calculate the terms in WACC.

The components of the WACC equation are calculated using the following financial data:

From the firm’s balance sheets:

 Period ending Last Fiscal Year Last Fiscal Year -1 Last Fiscal Year -2 Short term debt + Current portion of  long term debt (CMLTD) Long Term Debt Total debt, D

From the from the firm’s income statements:

 Period ending Last Fiscal Year Last Fiscal Year -1 Last Fiscal Year -2 Interest expense Income before tax Income tax

Other data:

 Firm’s current market capitalization (intraday stock price ∙ shares outstanding) See below. Firm’s beta, β See below. Return on the market, iM Assume 11% Risk-free rate, iF Assume 3%

The calculations in the table are based on the following:

1. Total debt, D, is the sum of Short term debt + CMLTD + Long Term Debt

2. Total equity, E, is the firm’s current market capitalization = current stock price times the number of shares outstanding. [Should http://thatswacc.com/ not be available, Market capitalization is available on the “Summary” page at the Yahoo Finance (http://finance.yahoo.com/) site for the stock.]

3. Total value of the firm, V, equals Total debt, D, + Total equity, E

4. Cost of debt, iD, = Interest pd in most recent fiscal yr/(Sum of total debt in last two fiscal yrs/2)

iD   = Interest expense/Average debt

1. Corporate tax, Tc, the firm’s corporate tax rate = Sum of prior three fiscal yrs’ Income tax expense/ Prior three yrs’ Income before tax

TC = Average Tax Expense/Average Income Before Tax

1. Firm’s cost of equity,

In the table if is assumed to equal 0.03 and iM is assumed to equal 11%. [Should http://thatswacc.com/ not be available, the firm’s beta, βE, is available on the “Summary” page at the Yahoo Finance (http://finance.yahoo.com/) site for the stock.]

[1]The accessibility of this site is assumed. Should it not be accessible, please follow the instructions in the Appendix at the end of this document.