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MBA 646 Financial Valuation – Homework 3   Please use the included spreadsheet to complete the assignments

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MBA 646 Financial Valuation – Homework 3

 

Please use the included spreadsheet to complete the assignments.

 

3-1 Calculating a Firm’s WACC

Nestlé Enterprises is estimating its cost of capital for the first time and has made the following estimates: The firm’s debt carries a AAA rating, which is currently yielding 6%; the firm pays taxes at a rate of 30%; the cost of equity is estimated to be 14%; and the firm’s debt is equal to 20% of its enterprise value.

1. What is Nestlé’s estimated WACC?
2. If Nestlé were to increase its debt level to 40% of enterprise value, the firm’s investment banker has told the firm that its credit rating would drop to AA and correspondingly its cost of debt financing would rise to 7%. If the cost of equity corresponding to this new capital structure were to rise to 16%, what would be the firm’s estimated WACC?

 

 

 

 

3-2 Calculating the Promised YTM Evaluate the promised YTM for the bonds issued by Ford (F) and General Motors (GM). You may assume that interest is paid semiannually. Also, round the number of compounding periods to the nearest six months.

1. Calculate the annualized yield to maturity as the cost of debt.
2. Find the cost of debt for given credit rating, which can also use the cost of debt.

 

 

 

 

 

3-3 Three-Step Process for Estimating a Firm’s WACC

Harriston Electronics builds circuit boards for a variety of applications in industrial equipment. The firm was founded in 1986 by two electrical engineers who left their jobs with General Electric (GE) Corporation. Harriston Electronics’ balance sheet for year-end 2014 describes a firm with $1,184,841,000 in assets (book values) and invested capital of approximately $2.2 billion (based on market values).

Harriston’s CFO, Margaret L. Hines, is concerned that its new investments be required to meet an appropriate cost of capital hurdle before capital is committed. Consequently, she initiated a cost of capital study by one of her senior financial analysts, Jack Frist. Shortly after receiving the assignment, Frist called the firm’s investment banker to get input on current capital costs.

Frist learned that, although the firm’s current debt capital required a 7.5% coupon rate of interest (with annual interest payments and no principal repayments until 2020), the current yield to maturity on similar debt had risen to 8.5% so that the current market value of the firm’s outstanding bonds had fallen to $624,385,826. Because the firm’s short-term notes were issued within the last thirty days, the 9% contract rate on the notes was the same as the current cost of credit for such notes.

1. What are Harriston’s total invested capital and capital structure weights for debt and equity? (Hint: The firm has some short-term debt [notes payable] that, like long-term debt, is also interest-bearing debt.)
2. Assuming a long-term US Treasury bond yield of 5.42% and an estimated market risk premium of 5%, what is Harriston’s cost of equity based on CAPM if the firm’s levered equity beta is 1.2?
3. What is your estimate of Harriston’s WACC? The firm’s tax rate is 35%.

 

 

 

 

3.4 Unlevering and Relevering Equity Betas

In 2006, the major airline carriers, with the principal exception of Southwest Airlines (LUV), continued to be in dire financial condition following the attack on the World Trade Center in 2001.

1. Given the following data for Southwest Airlines and three other airlines (for August 1, 2014), estimate the unlevered equity beta for Southwest Airlines.

 

 

2. We can use the average of the unlevered equity beta from the above 4 candidate stocks to get a more robust estimation of beta. Assume that Southwest Airline decide to use the average of the unlevered beta of the above four competitors as the estimation the unlevered beta, and raise the leverage from to 0.40, and tax rate remains the same, relever the beta to get an estimate of the firm’s levered beta.

 

 

 

 

3-5 Estimating the Cost of Equity Using the Fama-French Method

Telecom services is an industry under rapid transformation because telephone, Internet, and television services are being brought together under a common technology. In fall 2006, the telecom analyst for HML Capital, a private investment company, was trying to evaluate the cost of equity for two giants in the telecom industry: SBC Communications (AT&T) and Verizon Communications. Specifically, he wanted to look at two alternative methods for making the estimate: the CAPM and Fama-French three-factor model. The CAPM utilizes only one risk premium for the market as a whole, whereas the Fama-French model uses three (one for each of three factors). The factors are (1) a market risk premium, (2) a risk premium related to firm size, and (3) a market-to-book risk premium. Data for the risk premium sensitivities (b, s, and h) as well as the beta coefficient for the CAPM are listed in the following table:

 

 

1. If the risk-free rate of interest is 3%, what is the estimated cost of equity for the two firms using the CAPM?
2. What is the estimated cost of equity capital for the two firms using the Fama- French three-factor model? Interpret the meaning of the signs.