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 (firstname.lastname@example.org) 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 betas. 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 betas 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 betas that are 1.00. Discuss the management compensation strategy and suggest an alternative.
(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.