Dq 1&2

DQ1

Letter of my first name is C!

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:

o Use a risk-free rate of 4.0%.

o Use 6.0% as the market risk premium.

o For the beta, use the beta below, according to the first letter of your first name

First Letter of First Name Beta

A through B 0.30

C through D 0.40

E through F 0.50

G through H 0.60

I through J 0.70

K through L 0.80

M through N 0.90

O through P 1.00

Q through R 1.10

S through T 1.20

U through V 1.30

W through Z 1.40

• Calculate 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%.

o 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.

Dq2

“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 finance

• Read Chapter 8: Section 8.1: Perfect Capital Markets in Essentials of finance

• Watch the following video:

(Links to an external site.)

Meet Alexandra Clark//Owner, Bon Bon Bon (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 and Bon Bon Bon had primarily wholesale customers,

Clark talked about expanding into a full-time retail location. Suppose that Clark

considered buying a small building for the new, full-time retail location (rather than

renting space). 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 potential retail

building purchase?

o 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.