Case01-where-do-we-draw-the-line-(English)

WhereDoWeDrawTheLine?1.WhydoyouthinkPaulpreferstousetheWACCwhenanalysingproductacquisitionsratherthansomebaselinerateortherateonthecheapestcapitalcomponent?PaulpreferstousetheWACCwhenanalyzingproductacquisitionsratherthansomebaselinerateortherateonthecheapestcomponentsuchasdebt,becauseheiswellawarethatlenderstakenoteofdebtratiosandequitylevelsandwhencompaniesgetoverlyladenwithdebt,theircostofdebtgoesupasaresultofaratingdowngrade.Itisalwaysbettertohaveatargetcapitalstructureinmindandtouseitwhenevaluatingcapitalinvestmentproposals.19201921/2(1)(1/2)(1/2)ttDDCMPfRR´´=-=+++å2.HowshouldRongoaboutfiguringoutthecostofdebt?Calculatethefirm’scostofdebt?=6.91%213.82%(annualizedyield)DR?Fromthiscase,weknowthat:P=925，F=1000，T=38%，f=5%，r=12%C=F×r=1000×12%=120，/2=6.91%(semi-annualyield)DR'13.82%(138%)8.57%(aftertaxyield)DR=?=-3.Whyisthereacostassociatedwithafirm’sretainedearnings?HowcanRonestimatethefirm’scostofretainedearnings?Retainedearningsareundistributedearningsthatbelongtothecommonshareholdersofthefirm.Byretainingtheseprofits,thefirmispreventingtheshareholdersfromreinvestingthosecashflowsthemselves.Hence,theyhaveanopportunitycostassociatedwithsuchretentionsandthefirmshouldbeabletoearnarateequaltoorgreaterthanwhatthestockholderswouldhaveearnedthemselvesatthesamelevelofrisk.3.Whyisthereacostassociatedwithafirm’sretainedearnings?HowcanRonestimatethefirm’scostofretainedearnings?Method1:CAPMKs=KRF+(KM–KRF)×βAsKRF=4%，KM–KRF=9%，β=1.45Ks=4%+9%×1.45=17.05%Method2:DCFApproachKS=D1/P0+gg=(1-payout)×ROE=(1-30848/64266)×(64266/290681)=0.52×0.22=11.49%D1=D0×(1+g)=1.73×(1+11.49%)=1.93KS=1.93/18+11.49%=22.21%Method3:RiskPremiumKs=Kd+RPKs=Kd+RP=13.82%+6%=19.82%3.Whyisthereacostassociatedwithafirm’sretainedearnings?HowcanRonestimatethefirm’scostofretainedearnings?Method1:CAPMKs=KRF+(KM–KRF)×βAsKRF=4%，KM–KRF=9%，β=1.45Ks=4%+9%×1.45=17.05%Method2:DCFApproachKS=D1/P0+gg=(1-payout)×ROE=(1-30848/64266)×(64266/290681)=0.52×0.22=11.49%D1=D0×(1+g)=1.73×(1+11.49%)=1.93KS=1.93/18+11.49%=22.21%Method3:RiskPremiumKs=Kd+RPKs=Kd+RP=13.82%+6%=19.82%Arithmeticaverageis19.04%4.WhatareNuChem’scostsofnewcommonstockwhenthefirmraiseslessthan$50million,between$50millionand200million,andmorethan$200millionworthofnewequity?NuChem’scostofretainedearningsusingtheDCFapproach=22.21%LastPaidDividend=1.734769992RecentStockPrice=18GrowthRate=RetentionRate×ReturnonEquity=0.1149，whereRetentionRate=0.52ReturnonEquity=0.221087722CurrentDividendYield=0.0963761114.WhatareNuChem’scostsofnewcommonstockwhenthefirmraiseslessthan$50million,between$50millionand200million,andmorethan$200millionworthofnewequity?0-$50m$51-$200mGreaterthan$200mFlotationCostasaPercentofSellingPrice10%15%20%NetPrice=16.215.314.4DividendYield(D1/P)=11.90%12.60%13.39%CostofNewCommonStock23.39%24.09%24.88%FloatationCostEffect（kcs-kRE）1.18%1.88%2.67%+11.49%－22.21%5.WhatareNuchem’sweightedaveragecostsofcapital(WACC)asaresultofdifferentcostsofequity?YouwillneedtoidentifyeachlevelofnewcapitalraisedbeforefindingoutitscorrespondingWACC.CapitalStructureWeightsBookValueBookValueWeightLongtermDebt125,000,00030.07%Equity290,681,00069.93%TotalCapital415,681,000100%CurrentPrice#outstanding(000's)MarketValueMarketValueWeightLongtermDebt$925125000115,625,00026.54%Equity$1817782000320,076,00073.46%TotalCapital435,701,000100%5.WhatareNuchem’sweightedaveragecostsofcapital(WACC)asaresultofdifferentcostsofequity?YouwillneedtoidentifyeachlevelofnewcapitalraisedbeforefindingoutitscorrespondingWACC.CapitalStructureWeightsBookValueBookValueWeightLongtermDebt125,000,00030.07%Equity290,681,00069.93%TotalCapital415,681,000100%CurrentPrice#outstanding(000's)MarketValueMarketValueWeightLongtermDebt$925125000115,625,00026.54%Equity$1817782000320,076,00073.46%TotalCapital435,701,000100%5.WhatareNuchem’sweightedaveragecostsofcapital(WACC)asaresultofdifferentcostsofequity?YouwillneedtoidentifyeachlevelofnewcapitalraisedbeforefindingoutitscorrespondingWACC.BreakpointduetoRetainedEarningsrunningoutRetainedEarningsAvailable.Note:Forthecostofnewequity,usecostofretainedearningscalculatedbyDCFapproach.CurrentYear'sNetIncome('000s)64266Dividendspaid('000s)30847.68RetainedEarnings('000s)33418.32CostofEquityFirstBreakpointinMCCschedule=REavailable/EquityWeight45,490,43222.21%SecondBreakpoint=$83m/EquityWeight112,986,65023.39%ThirdBreakpoint=$233m/EquityWeight317,000,00024.09%317,000,00024.88%From$0-$45.4moftotalcapital:NewCapitalRaisedComponentCostWeightWeightedCostDebt=12,072,111.788.57%26.54%2.27%Equity=33,418,320.0022.21%73.46%16.32%45,490,431.7818.59%WACC1From$45.4M-$113mNewCapitalRaisedComponentCostWeightWeightedCostDebt$5,990,0058.57%26.54%2.27%Newshares$16,581,68023.39%73.46%17.18%19.45%WACC2From$113m-$317mNewCapitalRaisedComponentCostWeightWeightedCostDebt54,186,3498.57%26.54%2.27%Newshares150,000,00024.09%73.46%17.70%19.97%WACC3From$317monwardsNewCapitalRaisedComponentCostWeightWeightedCostDebt8.57%26.54%2.27%Newshares24.88%73.46%18.28%20.55%WACC4WhereDoWeDrawTheLine?IRRInvestmentAccumulatedInvestmentProject40.21119,000,000119,000