WACC Project
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Subject: Finance
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Your task is to select a company and calculate the capital structure that minimizes WACC and thus maximizes firm value. I have attached some PowerPoint to help.
Final Major WACC Project
Review the Final Major WACC Project Guidelines for instructions on completing this assignment.
Consider the following simple rules of observation to help determine the final results:
• If the Beta coefficient and the required rate of return on common equity is not increasing constantly as the amount of debt in the structure moves from 0% to increasing levels of debt, something is wrong.
• If the cost of debt does not fall and then begin to increase as the risks of bankruptcy increase, something is wrong.
• If the WACC curve does not display some type of U-shaped form (Note: You may have to make the vertical percentage cost scale have very small increments to show this.), something is wrong.
Format your final submission according to APA standards, and include reference and cover pages.
Background:
• Reference Brigham, Eugene F., and Ehrhardt, Michael, C., Financial Management, Theory and Practice, 14th Edition (2013). Chapter 15, Formula (15-2, p. 591), Hamada equations (15-9, 15-10, pp.610-611), & the process described on pages 608 through 614, plus graph on page 612 (Figure 15-7) are the “keys” to trying to determine the “optimal WACC.”
• The precise identification of the firm’s optimal capitalization structure is difficult, and depends a great deal on judgment of corporate officials and investment experts, as well as on the quality of data used in numerical calculations. Bottom-line is: only your study team can possibly know the “optimal WACC” for your selected company…and, it may not make that much of a difference in maximization of stockholder wealth from today’s “target WACC.”
Assumptions/”Givens”
• For the purpose of the project, assume no preferred stock.
• Similar to the textbook on pages 608-611, we will assume a zero percent (0.0%) growth rate in your company. (Otherwise, you will have to figure out future capital investments, and make adjustments in the “free cash flow (FCF)” calculations).
• For your target WACC, you will have determined what today’s cost of debt is for your company (usually, from existing corporate balance sheets or annual reports, or both). Now, for lower or higher amounts of debt, you have to (somehow) determine the costs of debt as the debt/equity ratio is changed. The textbook (Table 15-5, p. 610) illustrates this process for you. Rather than each team having to spend a lot of time visiting/calling bankers, we will use the following as “givens” for you:
• For each decrement or increment of 10% from your target ratio of debt and the corresponding debt costs, the debt costs decrease/increase by 10% from the target.
• For each decrement or increment of 20% from your target ratio of debt and the corresponding debt costs, the debt costs decrease/increase by 25% from the target.
• For each decrement or increment of 40% from your target ratio of debt and the corresponding debt costs, the debt costs decrease/increase by 60% from the target.
Example:
Assume the study team finds that Major Toy Company has a “target” debt/equity ratio of $100M / $400M = 25%, and that the current market costs of debt for Major (or a similar same size company with the same S&P/Moody’s Bond Ratings) are found in the annual reports/balance sheets to be 8%.
Thus, using the decrement/increment guidelines above, you will have:
Debt/Equity Ratio (% financed with debt) Costs of Debt (rd)
5% ———————– lower target rate by 25% —————————————— 6.0%
15% ——————— lower target rate by 10% —————————————— 7.2%
25% ——————— target WACC debt costs found by team (before tax) ——– 8%
35% ——————— increase rate by 10% ——————————————— 8.8%
45% ——————— increase rate by 25% ——————————————— 10.0%
65% ——————— increase rate by 60% ——————————————— 12.8%
• Corporate (federal+state+local) tax rate.
If you cannot readily determine what T value is (so that you can use it to calculate rd), then use our standard 40% tax rate!
(As an example) At this point, then, you can make this table:
% of Debt in Capitalization
Structure Cost of Debt ** After-Tax Cost of Debt Beta Coefficient Common Stock Cost WACC
5% 6.0% 3.60%
15% 7.2% 4.32%
25% 8% * 4.8%
35% 8.8% 5.28% To be
filled in
by
next
sections!
45% 10.0% 6.00%
65% 12.8% 7.68%
** Determined by multiplying the (before-tax) cost of debt by (1- the tax rate found for the company). I’m assuming T = 40% for this illustration.
• For use in determining owner’s equity costs for retained earnings at the “target” capitalization ratio to get rs (if you need to…you can always find the Beta coefficient from the financial web pages for just about any company) from the CAPM formula, you can use rRF = 4%, and market risk premium of 8% if you cannot determine them from financial sources. (Note: however, most study teams in the past have been able to find and logically support figures for these key parameters).
For example, assume your study team finds a Beta of 1.3 for Major Toy Company, effective December 31, 2006 to match the 25% debt cost of 8% at the same time (December 31, 2006). Then, rs (for target capitalization structure) = 4% + 1.3(8%) = 4% + 10.4% = 14.4%
Thus, for the “target capitalization” structure, the “target WACC” =
WACC = wd (rd)(1-T) + ws (rs)
= 0.25(8%) (1-0.4) + 0.75 (14.4%)
= 0.25 (4.8%) + 0.75 (14.4%)
COMPLETION OF MATRIX
= 1.2% + 10.8% = 12.0%
• Given the Beta and the 25% debt target ratio that the study team is presumed to have determined for Major Toy Company, the next step is to find what Beta would be if there was zero percent (0.0%) debt. This is called the “un-levered beta” and is found by equation 15-10 on page 623 (the Hamada equation) – take the Beta = 1.3 at 25% debt:
bu = b / [1 + (1 – T)(D/S)]
= 1.3 / [1 + (0.6)(25 / 75)
= 1.3 / 1 + 0.2
= 1.3 / 1.2
= 1.08
• Now that you know bu, you can find all the other Beta coefficient levels of debt in the structure, by using equation 15-9: b = bu [1 + (1 – T)(D/S)] = 1.08 [ 1+ (0.6)(D/S)]
% of Debt in Capitalization
Structure Beta Coefficient rs (Using CAPM)
0% 1.08% ** rs = rRF + B(mrp) =
= 4% + 1.08(8%) = 12.64%
5% 1.08(1+ 0.6(5 / 95) = 1.11 rs = rRF + B(mrp) =
= 4% + 1.11(8%) = 12.88%
15% 1.08(1+ 0.6(15 / 85) = 1.19 rs = rRF + B(mrp) =
= 4% + 1.19(8%) = 13.52%
25% 1.3 * rs = rRF + B(mrp) =
= 4% + 1.3(8%) = 14.4%
35% 1.08(1+ 0.6(35 / 65) =
(1.08)(1.323) = 1.43 rs = rRF + B(mrp) =
= 4% + 1.43(8%) = 15.44%
45% 1.08(1+ 0.6(45 / 55) =
(1.08)(1.491) = 1.61 rs = rRF + B(mrp) =
= 4% + 1.61(8%) = 16.88%
65% 1.08(1+ 0.6(65 / 35) =
(1.08)(2.114) = 2.28 rs = rRF + B(mrp) =
= 4% + 2.28(8%) = 22.24%
* Determined to be 1.3 for Major Toy Company at target debt/equity ratio.
** Un-levered Beta determined by Hamada equation.
FINAL WACC CALCULATIONS
% of Debt in Capitalization
Structure (rd)
After-Tax Cost of Debt (%) rs
(%) WACC = wd (rd)(1-T) + ws (rs)
(%)
0 N/A 12.64
= 0 + 100(12.64) = 12.64
5 3.60 12.88
= 0.05(3.60) + .95(12.88) = 12.42
15 4.32 13.52
= 0.15(4.32) + .85(13.52) = 12.14
25 4.8 14.40
= 0.25(4.80) + .75(14.40) = 12.00
35 5.28 15.44
= 0.35(5.28) + .65(15.44) = 11.89
45 6.00 16.88
= 0.45(6.00) + .55(16.88) = 11.98
65 7.68 22.24
= 0.65(7.68) + .35(22.24) = 12.78
CONCLUSIONS
• The “target capitalization structure” at 25% debt is NOT the optimal capitalization structure!
• According to the data provided (and assumed), the optimal capitalization structure is at a 35% debt / 65% equity ratio, with the WACC at the lowest level of 11.89%.
• Refer to the following graph:
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0.00
0.10
0.20
0.30
0.40
0.50
0.60
0.70
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0.90
1.00
% of Debt in Structure
“Optimal WACC” at debt level of 35%
Initial “target WACC” at debt level of 25%
• Stockholder wealth maximization theories require that Major Toy Company immediately move from 25% to 35% debt levels…become more financially leveraged in order to maximize wealth to the stockholders.
