WACC Rationale - Grade: A PDF

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An extensive explanation of the weighted average cost of capital. ...

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Name: Tanya Kamaly Module: Financial Risk Management

An explanation of the rationale behind the method of calculation you have used, and a consideration of some of the assumptions implied in it. Weighted Average Cost of Capital In all WACC calculations market value should be used instead of book value as it reflects the current markets insight of the company. It also reflects future cash flow expectations and future risks. The book value debt shows the redemption, but doesn’t take in consideration credit risks. The book value for equity is derived from published accounts (issued capital + retained earnings and reserves) implying this is historical data, and doesn’t reflect the current market. In order to calculate the WACC I first calculated the cost of equity then cost of debt. Cost of Equity The rate of return on shares is annual dividend + growth. Since the current dividend and expected dividend growth rates are given I have used the Gordon Growth model as it is most appropriate. The model uses the current share price and the next expected dividend and then adds future growth rate to forecast the rate of return. The motive behind this method of calculation is shareholders expect this rate of return given the dividend information. If the actual rate is lower shareholders may sell their shares causing the share price to fall and if the share price is higher this increases share demand, which in turn increases share price. Cost of Debt Given that 9% is priced at par non-marketable debt calculation can be used which is Coupon – Tax. This is because the coupon payable is the return debt holders want. The use of IRR takes into account the actual cash flows and market value of the bond giving a more accurate cost of debt, and this should be used for marketable debt unless it’s priced at par (£100). The IRR calculation takes into time value of money and the change in bond prices between now and maturity. IRR is estimated by interpolation of 2 discounts factors which give both a positive and negation NPV. The choice of the 2 discount factor impacts the IRR by a small amount. The lesser the gap between the discounts factors the more accurate the IRR is. IRR is not a linear calculation, so wide gaps between rates can distort the calculation.

Name: Tanya Kamaly Module: Financial Risk Management

Assumptions implied in the above Calculations Equity and Gordon Growth Model The dividend growth rate remains a constant. Also, 12% is high from a historical point of view. It could be doubtful that a high rate could be achieved given Porters findings and its 5 forces. There are problems in forecasting the rate of growth since the question arises should past growth rates be used and how accurate would forward looking forecasts be? If shareholders are not satisfied by their return they will sell their share which put downward pressure on the share price. The model assumes a dividend will be given which in reality isn’t an obligation for companies. Lastly the Gordon Growth model doesn’t take account risk. Cost of Debt The calculation assumes that the companies tax rate it 30%, where as in practice not all companies pay 30%. If companies have made losses in the past they maybe ‘tax exhausted’ in which case the gross coupon should be used in the Kd calculation. For cost of marketable debt the assumption is cash flows occurs at the end of the year with tax relief. This usually doesn’t occur in practice The calculation also assumes companies buy the entire bond at the market price. The IRR calculation is more accurate than the Hawawini and Vora (1982) bond calculation as it considers the time value of money. The greater the difference between current market price, nominal value and the greater the time maturity is the more important it is to use the IRR method....