Capital budgeting involves decisions about whether or not to invest in fixed ass
ID: 2685818 • Letter: C
Question
Capital budgeting involves decisions about whether or not to invest in fixed assets, and it has a major influence on firms' future performances and values. Discounted cash flow analysis is used in capital budgeting, and a key element of this procedure is the discount rate used in the analysis. Capital must be raised to finance fixed assets, and this capital comes from different sources: debt, preferred stock, and common equity. Each of these capital components has a cost, and these cost rates, along with the target proportions of each, are used to calculate the firm's weighted average cost of capital or "WACC." Go to http://ro.uow.edu.au/commpapers/317/. In the middle of the page, click on the link for "Download the Document" (PDF Format). This will open a new document in Adobe Acrobat. Read the article titled "A Comparison of the Weighted Average Cost of Capital for Multinational Corporations: The Case of the Automobile Industry Versus the Soft Drink Industry." After you have completed the above, answer the following question: Identify some problem areas in the cost of capital analysis. Do these problems invalidate the cost of capital procedures we are discussing in this unit?Explanation / Answer
The current (2/23/08) Market Cap is $211.42 billion.
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Short-term debt is $9.733 billion and long-term debt is $50.063 billion.
The total capital (the sum of these three components) is $305.946 billion.
The weights are: wce = $211.42 /$271.2160 = 77.95%; wSTD = $9.733 /$271.2160 = 3.59%; and wLTD = $50.063 /$271.2160 = 18.46%.
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The reported beta (2/23/08) is 0.99.
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The 6-month yield (on 2/23/08) is 2.06% and the 10-year yield is 3.80%.
e. Apply the Capital Asset Pricing Model (CAPM) Security Market Line to estimate rs for AT&T. Assume a market risk premium (rm - rRF) of 6.0%. Use the yield on a 10-year Treasury bond (found earlier in the problem) as an estimate of the risk-free rate.
rs = 3.80% + 0.99 x ( 6.0% ) = 9.74%.
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The bond rating from Moody’s (as of 2/23/08) is A2. The shortest spread is 120 basis point, or 1.20%. The 10-year spread is 160 basis points, or 1.60%. The cost of short-term debt is:
rSTD = 2.06% + 1.20% = 3.26%.
rLTD = 3.80% + 1.60% = 5.40%.
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g. Assume AT&T has an effective tax rate of 35% and using the component weights, the component costs, and the tax rate, estimate the weighted average cost of capital.
WACC = rs (wce) + rLTD (1-T)(wLTD) + rSTD (1-T)(wSTD)
WACC = 8.32%.
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