**Objective**

The objective of this learning module is understand how to assess the cost of capital for a particular firm. We also explore the implications of the cost of capital for project evaluation and management compensation.

**Note:** This is a group assignment. Please turn in one document
for each team. You can choose one or two firms to study. I recommend you
choose one firm that has equity traded on a major exchange.

**1. Risk assessment **

**(a)** Collect monthly data the stock price and MSCI world market
portfolio. Contact Jane Day (*jnday@mail.duke.edu*) for the data.
You will receive a CSV file which you can easily read into Excel. The date
field may have the 28th of the month for each month. This is just a quirk
of DATASTREAM. We have actually pulled the last day of the month). Convert
prices into returns for the past 10 years. Work in U.S. dollar terms. Estimate
*beta *by regressing the firm return on the MSCI world return (do
not worry about the risk free rate for this part). Estimate the *beta
*over rolling 5-year periods (60 months) (i.e., years 1-5, 2-6, 3-7,
...). Report the five *beta*s. Comment on the magnitude of the *beta
*(e.g., high *beta *associated with high risk industry, low with
Blue Chips). Comment on the changes in *beta *over time if there where
any (e.g. if the *beta *has gone up is this associated with a change
of business lines for the firm?).

**(b)** Investigate the capital structure of the firm. Approximate
the firms weighted average cost of capital (WACC). Use the *beta *from
the most recent five year period. Assume that the risk free rate is 5%
and the expected return on the MSCI world portfolio is 13%. The key word
here is *approximate*. To complete this exercise for a firm with leverage
could be very time-intensive, because we would have to figure out the market
value of each bond in the capital structure. Instead, just approximate
the market values using book values and note that if the coupon rates are
far away from market rates, then book value will substantially differ from
market value. Further assume, the *beta*s of the debt are the following:
short term debt = 0; Aaa,Aa,A = 0.1; Baa = 0.2; Below Baa = 0.3 where I
have used the Moody's ratings. (Make a blanket classification of all debt).
If these ratings are not available to you, just extrapolate and use judgement.
Finally, assume that the marginal tax rate is 34%. If you have information
suggesting that the marginal tax rate is different for your particular
firm, then use it. **(c)** [OPTIONAL] Compare your cost of capital with
the cost of capital from my Global
Cost of Capital Calculator. This just calculates the cost of capital
for a 100% equity firm that has average risk in each particular country.
If your firm is domiciled in the U.S., select U.S. Also, select one year
horizon. The method works of credit ratings. I recommend you choose the
Institutional Investor Credit Ratings.

**2. Project evaluation and the Weighted Average Cost
of Capital **

**(a)**Suppose you are thinking of acquiring a new business unit.
The acquisition promises to return 4% more than the WACC that you calculated
in the previous question. Is it obvious that this acquisition will increase
shareholder value (i.e., stock price)?

**(b)**Suppose you are thinking of acquiring a new business unit.
The acquisition promises to return 2% less than the WACC that you calculated
in the previous question. Is it obvious that this acquisition will decrease
shareholder value (i.e., stock price)?

**3. Performance Evaluation of Managers**

**(a)** Suppose the firm has two business units. One unit produces
handheld computers. The other unit is involved in retailing. Each division
is currently the same size. The firm's management understands the CAPM
and has calculated the **WACC to be 16%** (asssume no debt in the capital
structure, assume **risk free rate = 5%**, **market premium = 8%**
and ** beta = 1.375** [verify WACC]). They institute the following
rule. Division management will be given bonuses only if they return more
than 16% on invested capital. You are also told that similar firms which
simply have a retail unit (again with no debt) have

**(b)** Add another dimension to your critique. The compensation
scheme only addresses next year's returns. But stock price is determined
by all future years - not just next year. Do you have any ideas as to how
to account for the longer term determinants of the firm's value in the
compensation scheme.