BUS 401 University of Arizona Principles of Finance Discussion
Cost of Capital [WLOs: 1, 2] [CLOs: 2, 3, 4]In the constant growth formula, you can use the required rate of return on equity to determine the value of a share of stock. However, when you are computing the value of an investment project, you cannot assume the project is entirely funded by equity. Most businesses, and most projects, are funded with a combination of debt and equity financing. As a result, the discount rate for the project has to reflect the required rates of return for the debt holders and the equity holders. Analysts compute the weighted average cost of capital (the WACC) to value projects. The WACC is a weighted average of the required returns for the debt and equity holders, based on the proportions of debt and equity in the capital structure. In this discussion, you will practice calculating the WACC and interpreting its meaning and application.Prepare:Prior to beginning work on this discussion forum,Complete the Week 5 – Learning Activity.Read Chapter 10 in Essentials of finance.Imagine that you own a company, Optimus, Inc., which is funded with 40% debt and 60% common stock; there is no preferred stock in the capital structure. The debt has an after-tax cost of 4%. You have studied the Electrobicycle project, and you believe that the auto company who has done the research and development (R&D) has made a crucial mistake. You believe that after the first 5 years, there will be worldwide expansion opportunities and many more years of revenues and earnings from selling Electrobicycles. Thus, you would not shut down the project in Year 5. Instead, you believe you will be able to sell the Electrobicycle business in Year 5 to a multinational company that will continue to produce the products and sell them internationally for many years into the future. You believe the sale of the Electrobicycle business in Year 5 will be for at least $15.0 million. Thus, you believe the value of the Electrobicycle project is significantly higher than the auto company realizes.For the initial post,Calculate Optimus’ required rate of return on equity using the capital asset pricing model (CAPM). For the CAPM, use the following assumptions:Use a risk-free rate of 4.0%.Use 6.0% as the market risk premium.For the beta, use the beta below, according to the first letter of your first nameFirst Letter of First NameBetaQ through R1.10Calculate the WACC for Optimus. As a reminder, Optimus is funded with 40% debt and 60% common stock; there is no preferred stock in the capital structure. The debt has an after-tax cost of 4%.Use the Optimus required rate of return on equity that you calculated using the CAPM.Explain why it is appropriate for Optimus to value the Electrobicycle project using its WACC. Compare using the WACC to using solely the cost of equity in valuing the Electrobicycle project.///////////////////////////////////////////////////////////////////////////////////////BREAK!!!!!!!!\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\ Leverage and Capital Structure [WLOs: 2, 3] [CLO: 3]“The use of debt to fund the firm (called leveraging) carries with it benefits as well as risks” (Hickman et all., 2013, Chap 8, Overview, para. 4). In the short term, leverage lowers the weighted average cost of capital due to the typically lower required rates of return on debt as compared to equity. In the long run, debt requires interest payments and the principal must be repaid. A firm that cannot repay its debt faces default risk and/or bankruptcy. The risks due to excessive leverage are known as financial risks. Thus, as a firm considers using debt or equity to fund its business, it must consider both the benefits of debt and the financial risks of too much debt. In this discussion, you will evaluate a real-world scenario and consider the implications of the debt financing decision for the firm.Prepare:Prior to beginning work on this discussion forum,Complete the the Week 5 – Learning Activity: Understanding Cost of Capital.Read Chapter 10 in Essentials of financeRead Chapter 8: Section 8.1: Perfect Capital Markets in Essentials of financeWatch the following video: (Links to an external site.)How Alex Clark Turned $32,000 Into a Chocolate Phenomenon - 30 Under 30 | Forbes (Links to an external site.)After watching the video, answer the following questions in your post:Did Alex Clark initially fund the business with equity or debt?Initially, Clark’s chocolate business is very small. Compared to publicly traded companies, would Clark’s required rate of return on equity be higher or lower than the “average” required rate of return on equity for small cap companies of 15%? Explain your answer.After the business was established, Clark talked about buying a building to expand. This is a good example of an investment project that a business must evaluate. Would the required rate of return for Clark’s building purchase be higher or lower than the overall chocolate company’s required rate of return? Explain your answer.Should Clark use some bank debt to finance all or a portion of the building purchase?Justify your answer by explaining how the weighted average cost of capital for the company would change if Clark uses bank debt to finance all or a portion of the building purchase.What is the primary risk that Clark faces if she uses debt to finance the entire building purchase? For purposes of this discussion, assume that the debt would then comprise 95% of the company’s capital structure.