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Maconie Inc. is a corporation that operates bus, rail and taxi services in Toronto, Canada and is a listed company. The company has been successful in recent years, with passenger numbers growing dramatically and financial performance and financial position being strong. Recently, Maconie Inc. has been awarded contracts to operate several new bus routes in Toronto.
Before investors put their money into a particular company, the first step involves project valuation. During the valuation of the project, it is important that the investor does a cash flow analysis to base their decisions on whether they want to invest in the project. Once the investor approves of the project and deems it viable, it becomes important to make a decision to finance. Financing involves looking at the best option available to run the project. The financing option could involve a mixture of both equity and debt. Other times it may involve financing through equity or through debt exclusively. The decision depends on the availability of the funding option and the costs it might incur. To make the decision, the investor might evaluate the investment appraisal using the Weighted Average Cost of Capital which implies a sum of equity and debt (Miles, 1980).
WACC represents an after-tax cost of capital. While calculating WACC, the debt cost gets drawn from interest rates corrected for tax. The interest charge further gets set normally for the duration of the credit. The lender of the loan often needs it repaid regardless of how the business performs financially. The cost of equity, on the other hand, can either be estimated using the Capital Asset Pricing Model (CAPM) or Gordon's Wealth Growth Model, also known as the Dividend Discount Model (DDM). However, the same can be calculated using other models for instance the Arbitrage Pricing Theory (APT). Equity costs are often outlined as the estimated return on the corporate stocks of an asset in capital markets (Miles, 1980).
Investors are often expected to take into account investment risks when they determine the expected returns since there is a risk that the investor may not get the returns they expect. Notably, the relationship between risks and expected returns of a stock are in a way that an upturn in risk results in an escalation in the expected return on investment. Performing a proper analysis of a stock helps determine the true value of stock and to forecast its future expected returns. While estimating equity cost a number of methods and different assumptions result in different outcomes. For Maconie Inc. the use of the two models, Capital Asset Pricing Model and the Dividend Discount Models assist to analyze the stocks of the company and to decide on the projects that best suits investors (Witmer, 2008).
Task 1: Financing the Acquisition of New Buses
Calculation of Maconie Inc. Current Weighted Average Cost of CapitalThe formula for estimating the Weighted Average Cost of Capital is given by: WACC= ((Eq/Vl)*Re) + [((Dt/Vl)*Rd)*(1-Tr)]; Where, Eq represents the value of equity as per the market. Dt represents the worth of debt as per the market. Vl signifies the corporation's total worth of market, Re signifies equity cost. Rd is the debt cost or the yield to maturity and Tr is the tax rate. The market worth of equity is computed as the product of the share market price and the amount of shares issued (Miles, 1980). With the share market price at $2 and the amount as 80 million shares issued, the market value of equity stands at $160 million. On the other hand, the market worth of debt is calculated as the product of bonds issued and the bonds trade. The company had 1 million bonds in issue with the bonds trading at $50 each. Therefore, the market value of debt stands at $50 million. The total market value of the company, therefore stands at $210 million.
Using the Gordon Growth Model to calculate WACC, we obtain the equity cost (Re) using the formula: Re = (D1/P0) + g, where D1represents the dividends. However, since the company uses future dividends, the formula shifts to Re = ((D0 (1+g))/P0) + g (Penman, 1998). In the formula, D0 stands for the company's last year's dividend paid, g is the dividend growth rate, estimated at 5.5024% and P0 represents the share price at $2. The last year's dividend paid by the company stands at 15 cents or $ 0.15 according to table 2, therefore, the market value of equity becomes ((($0.15*(1+0.055024))/$2) + 0.055024) which translates to 13.415%. The market worth of debt, conversely translates to the yield to maturity of company bonds, given as 9% and the tax rate is given as 22%. Therefore, WACC for the company is computed as: WACC = ((160/210)*13.415%) + [((50/210)*9%)*(1-0.22)] which translates to 11.98%.
Using the Capital Asset Pricing Model to calculate WACC, we obtain the equity cost (Re) using the formula: Re = Rf + beta(Rm - Rf) (Ross, 1977). Where Rf stands for the risk free rate given as 8% for the company, Rm represents the market rate of return given as 14% for the company and beta given as 1.42. Therefore, Re is given by 8% + 1.42*(14% - 8%), which turns out to be 16.52% for the company. Therefore, the WACC according to the Capital Asset Price Model becomes ((160/210)*16.52%) + [((50/210)*9%)*(1-0.22)] which translates to 14.25%.
Contrast between CAPM and DDMFrom the two models, the calculated WACC using Capital Asset Price Model (CAPM) differs from calculation using Dividend Discount Model (DDM). CAPM is a one phase pricing simulation and corporations use it to calculate equity cost. CAPM depends on historical evidence to estimate a progressive equity cost for the company (Ross, 1977). However, in other circumstances, the past does not forecast the future accurately. As a result, therefore, it can lead to application of an unfitting discount rate. DDM on the other hand, attempts to lessen the problem of reliance on historical data to forecast the future. Instead, it compares the stream of predictable dividends for the future with current prices of shares CITATION Pen98 \l 2057 (Penman, 1998). Since Gordon's Growth model depends mainly on the dividends of the company, and therefore uses predictions of future dividends to calculate the WACC the results are more accurate than if the CAPM was used.
From the formula WACC= ((Eq/Vl)*Re) + [((Dt/Vl)*Rd)*(1-Tr)], it is also accurate to say that WACC= ((Dt/Vl)*(1-Tr)*Rd) + (Eq/Vl)*Re, which then translates to WACC being (1-(Dt*Tr/Vl))*R0. In the formula, R0 represents the discount rate of assets after taxes, Dt represents the debt as per the market value, Tr represents the corporate tax rate, Vl represents the firm's value as per the market, Rd represents the debt cost, Eq is the equity value as per the market and Re represents the equity cost. When reordered, the formula becomes Re=R0 + (Dt/Eq)*[(R0 - Rd)*(1 - Tr)] (Miles, 1980).
Use of WACC as Discount RateSometimes choosing the right discount rate for a corporate investor may be challenging. Some corporations often resort to using WACC when choosing a discount rate for making financial choices. Companies are usually funded by debt or equity although other companies use retained earnings as well. The retained earnings refer to earnings after tax that do not get distributed to the shareholders as dividends. Therefore, WACC can be said to be the weighted average of these sources of financing for the particular company (Miles, 1980). Other times WACC can also be referred to as the hurdle rate. Usually, for a company to be beneficial, it has to gain a greater return than its capital cost, also metaphorically known as crossing the hurdle.
More often than not, commercial banks provide debt fractions of the capital structure in the form of short-term unsecured. On the other hand, bond investors provide long-term debts for the company. Preferred and common stocks in the company make up the equity fraction of capital. The paid interests on both long-term and short-term debt is usually deductible for the tax purposes. However, dividends that gets paid to stockholders is not deductible. WACC, therefore, becomes the most appropriate discount rate for corporate investors. For any investment company, implications are that the returns above the WACC would result into additional value for the company (Miles, 1980). For example, in Maconie Inc. any return greater than 14.25% implies additional value for the company while returns below 14.25% destroys value for the company.
Task 2: Investment in the New Buses
Critical evaluation of the four business optionsBy using the WACC as calculated through CAPM above as the discount factor, can evaluate the four business options from table 3 in the appendix. The table depicts business options for Maconie Inc to invest in. using the net present value technique it is possible to deliberate on which one of the four seems better for the company to invest in instead of the fleet of buses as requested by the stockholders. The discount factor therefore becomes 0.1425. The formulas to calculate net present value are; NPV= W*[(1-(1+R)-T)/R] - investment at the start, if each interval produces returns in equivalent amount. However, if the projects produce returns at fluctuating rates over time the formula to use becomes NPV= [(W for interval 1/ (1+R) 1) + (W for interval 2/ (1+R) 2) + ... + (W for interval x/ (1+R) x)] - initial investment. Where W represents the working capital and R represents the discount rate (Shrieves, 2001).
For the first business option, the NPV would be given by [(2/ (1+0.1425)) + (2/ (1+0.1425)2) + (6/ (1+0.1425)3) + (1/ (1+0.1425)4)] - 10 which would relate to -2.1071. The second business option would have NPV given by 1*[(1-(1+0.1425)-4)/0.1425] - 2 which gives 0.8989. The third business option would be given by [(4/ (1+0.1425)) + (4/ (1+0.1425)2) + (2/ (1+0.1425)3) + (2/ (1+0.1425)4)] - 8 which gives 1.0803. The final business option would be given by 3*[(1-(1+0.1425)-4)/0.1425] - 12 which gives -3.3031. In choosing the most suitable business to venture, business options with negative NPV should often be rejected. Therefore, business options A and D should be rejected. For business...
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