13. Part B, Web-based Exercises:
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html In prior Ch. 12 HW Part B, we find from online data source that the long-term average expected return for US stock market (Rm) was xx.xx% per year, while the long-term average expected return for US “risk-free” T-bill (Rf) was xx.xx% per year. Furthermore, via Money MSN, under CAT’s “Quote”==>””Financial Highlights” (just below where you found CAT’s “dividend rate” amount in Ch. 08 HW), we can find CAT’s systematic risk “Beta” value is given as x.xx.
(1) Use those given data from web sources, plug them into the CAPM formula E(Ri) = Rf + BETAi * [E(Rm) – Rf], and calculate “what is E(Ri), i.e., the fair expected or required return for CAT stock in market equilibrium?”
(2) Remember in Ch. 08 HW, how did we use “dividend growth model”, P0 = D0 * (1 + g) / (R – g), to calculate CAT’s fair price in market equilibrium? Well, back then the required return R is given subjectively as either “11.26%” or “1.63%” (just as a matter of wild guessing). Now, after studying Ch. 13, we know how to objectively estimate the expected or required return as a matter of fact, e.g., by using the market-data-based CAPM calculation answer for E(Ri).
Use your calculated E(Ri) from the aforementioned HW step (1), plug it as R into the dividend growth model formula, and recalculate “what is P0, i.e., the fair price for CAT stock in market equilibrium?”
Part B, Web-based Exercises:
Please note: “cost of capital” is the same as “required return (i.e., expected return)” of capital, and “security market line” SML is the same as CAPM.)
14. (1) According to http://finance.yahoo.com, “Key Statistics”, what are the given values of CAT’s “Market Cap (for equity)” E and “Total Debt” D, respectively? And thus what shall be CAT’s “weight of equity capital, We” and “weight of debt capital, Wd”, respectively?
Hints: For example, if a firm’s reported “Market Cap” is $75 billion, “Total Debt” is $25 billion, then We = 75 bil / (75 bil + 25 bil) = 75 bil / 100 bil = 0.75 (or 75%), and Wd = 25 bil / (75 bil + 25 bil) = 25 bil / 100 bil = 0.25 (or 25%).
(2) Based on the aforementioned existing capital structure weights, and the findings from previous chapter exercises:
From Ch. 10 HW Part B, Application 1, we find that CAT’s cost of longest-term debt Rd (e.g., CAT’s longest-maturity bond YTM) = 5.181% per year;
From Ch. 10 HW Part B, Application 2, we find that when we use dividend growth model DGM, CAT’s cost of common stock equity Re (e.g., CAT stock’s required return) = 4.54% per year;
From Ch. 13 HW Part B, we find when we use capital asset pricing model CAPM, CAT’s cost of common stock equity Re (e.g., CAT stock’s required return) = xx.xx% per year;
Hints: Since neither DGM nor CAPM is perfect (the former uses current data but ignores market risk, can’t be applied on stocks that pay no dividends, so it is “current but not stable”; the latter considers market risk but relies on outdated historical average data, can be applied on stocks that pay or do not pay dividends, so it is “stable but not current”), the best method to estimate Re shall be “the average of both DGM and CAPM outcomes.”
An applicable corporate tax rate is given as Tc = 35% (Federal income tax only) for CAT.
Based on the aforementioned data, compute CAT’s WACC.
(3) Let’s recall the prior exercises in Ch. 10, and see what the WACC shall be used for.
In “HW for Chapter 10, Part B” Caterpillar exercises, we find that to finance capital investment projects,using debt capital alone will cost relatively less [particularly after multiplying yield-to-maturity Rd with (1 – Tax rate), with tax deduction benefit on corporate debt interest expenses] but will increase the bankruptcy risk; while using equity capital alone will lower the bankruptcy risk but the cost of equity could be higher compared with the after-tax cost of debt capital. So, the best way to finance an investment project while keeping the firm’s growth sustainable is to “use some debt, and use some equity, therefore keeping the existing debt-equity ratio constant and not off-balance.” As a result, the best required return (i.e., discount rate, or cost of capital) for an investment project is the firm’s WACC, which is the weighted average of debt and equity capital!
Based on the required return (financing cost) of WACC we calculate in Step (2), if CAT applies the IRR rule, shall CAT purchase the order entry system described in Ch. 10, Ex. 14 or not?
Based on the required return (financing cost) of WACC we calculate in Step (2), If CAT applies the NPV rule, what shall be the NPV amount, and shall CAT purchase the order entry system or not?