QUESTIONS FOR THE OVERALL ASSIGNMENT
1. What is the best way to estimate the company and divisions’ cost of capital?
The best way to estimate the cost of capital is by using the CAPM (Capital Asset Pricing Model) where the Weighted-Average Cost of Capital (rwacc) is given by the formula
D is the market value of the net debt
E is the market value of the total equity
V is the total market value of debt and equity = D + E
T is the corporate tax rate
rd is the appropriately calculated discount rate for debt (cost of debt)
re is the appropriately calculated discount rate for equity (cost of equity)
However, the equity market value of the division can be estimated from the present value of its future equity cash flows discounted at an appropriate rate. This equity discount rate for the division (re) can be estimated from observing the stock prices and market values of other companies (‘pure play’ approach) engaged in similar business as the division with similar risk.
2. Should it be calculated differently for different purposes?
The cost of capital should be calculated differently for different purposes. It should be based on actual interest rates paid on debt for tax accounting purposes (tax accounting does not recognize the concept of cost of equity so there is no rate that can be applied for the cost of equity). The cost of capital for financial accounting purposes will need to be calculated based on financial accounting rules using actual interest rates for debt and the accounting return on equity. The cost of capital for all other ‘internal business decision purposes’ Capital budgeting, Performance assessments, Merger & Acquisition proposals, and Stock-repurchase decisions should be based on the CAPM model and appropriate market-value based and risk-based estimated discount rates for debt and equity. The risk levels and hence the risk premiums required could differ for different decisions and purposes. For example, the risk premium required for a M&A proposal (Merger and Acquisition) should be based on the estimated incremental market value due to the M&A whereas the risk premium required for capital budgeting should be based on the company’s established operations in the current and future lines of business and investments.
Questions to specifically address
1. What is the appropriate risk-free rate to use in the WACC calculations? How did you arrive at this number?
The appropriate risk-free rate to use in the 2007 WACC calculations is 4.98%, the rate of 30-year U.S. Treasury bonds in 2007. The rate is specified in the case, in Table 2. Team 1 compared the rate to U.S. Treasury data online (See Exhibit 1); while the rate from the case is slightly different than the average rate found online for the January 2007 average (4.85%), the Team will use the rate specified in the case. The 30-year rate is used for the risk-free rate because the majority of large firms and financial analysts report using long-term yields for bonds to determine the risk-free rate.
The appropriate risk-free rate to use for the Exploration and Production division is also the 30-year Treasury rate of 4.98%.
2. What is the Market Risk Premium (EMRP) that is most appropriate to use in the calculation for the cost of equity? How did you arrive at that number?
The appropriate EMRP to use in the 2007 WACC calculation is 6.0% as listed in Table 2. Team 1 compared this rate to real-world data using the average annual total return on common stocks from Yahoo! Finance and the risk free rate from Exhibit 1.