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Project

AI Summary

This assignment involves estimating the weighted-average cost of capital (WACC) for a listed company using publicly available data. The WACC is calculated by combining the risk-free rate, market risk premium, and equity beta using the Capital Asset Pricing Model (CAPM). Estimation of individual parameters includes setting the capital structure, calculating the risk-free rate from government bond yields, estimating the equity beta using regression analysis or comparable firms, and adjusting for differences in capital structure. The project requires collecting data on the company's financial statements, market value of debt and equity, and estimates of the asset beta from comparable firms.

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Finance Assignment

Weighted-average cost of capital

This assignment involves the estimation of the weighted-average cost of capital of a listed company

using publicly available data. You can pick any company you like. However, this project will

require several pieces of data, which will be easier to track down for larger well-known companies.

You probably also want to select a company with a single business unit – otherwise you really

should be estimating a different WACC for each different business unit and then aggregating those

estimates at the end. In summary, you probably want a well-known listed firm that has a single line

of business. You should try to avoid banking stocks as leverage has a somewhat different

interpretation for them.

You’ll then need estimates for each of the parameters in the WACC equation:

WACC r 1

E

r

D

e

1

1

V

d 1 .

V

where you’ll use the CAPM to estimate the required return on equity:

Some hints about how to estimate the individual parameters:

1. Capital structure (i.e., the relative proportions of debt and equity capital) is usually

computed by:

a. setting to the market value of equity or market capitalisation (the number of shares

multiplied by the current share price), which is easily available on many finance web

sites; and

b. setting to the book value of interest bearing liabilities (the sum of short-term and

long-term debt), which is available in the company’s most recent financial

statements in its annual report. Ideally, we would want the market value of debt, but

this will be unavailable because it includes bank loans etc. Also, market value and

book value are likely to be reasonably close for debt, but not for equity.

Some finance web sites also provide estimates of gearing, but be careful here as they are

usually book value estimates (i.e., they may be based on the book value, rather than the

market value, of equity).

2. The risk-free rate is usually set to the current yield on long-term government bonds. The

RBA provides this sort of data at:

http://www.rba.gov.au/statistics/tables/xls/f02d.xls.

3. The equity beta is usually estimated using regression analysis. I don’t expect you to obtain

raw data and run these regressions yourselves – equity beta estimates are readily available

on

Weighted-average cost of capital

This assignment involves the estimation of the weighted-average cost of capital of a listed company

using publicly available data. You can pick any company you like. However, this project will

require several pieces of data, which will be easier to track down for larger well-known companies.

You probably also want to select a company with a single business unit – otherwise you really

should be estimating a different WACC for each different business unit and then aggregating those

estimates at the end. In summary, you probably want a well-known listed firm that has a single line

of business. You should try to avoid banking stocks as leverage has a somewhat different

interpretation for them.

You’ll then need estimates for each of the parameters in the WACC equation:

WACC r 1

E

r

D

e

1

1

V

d 1 .

V

where you’ll use the CAPM to estimate the required return on equity:

Some hints about how to estimate the individual parameters:

1. Capital structure (i.e., the relative proportions of debt and equity capital) is usually

computed by:

a. setting to the market value of equity or market capitalisation (the number of shares

multiplied by the current share price), which is easily available on many finance web

sites; and

b. setting to the book value of interest bearing liabilities (the sum of short-term and

long-term debt), which is available in the company’s most recent financial

statements in its annual report. Ideally, we would want the market value of debt, but

this will be unavailable because it includes bank loans etc. Also, market value and

book value are likely to be reasonably close for debt, but not for equity.

Some finance web sites also provide estimates of gearing, but be careful here as they are

usually book value estimates (i.e., they may be based on the book value, rather than the

market value, of equity).

2. The risk-free rate is usually set to the current yield on long-term government bonds. The

RBA provides this sort of data at:

http://www.rba.gov.au/statistics/tables/xls/f02d.xls.

3. The equity beta is usually estimated using regression analysis. I don’t expect you to obtain

raw data and run these regressions yourselves – equity beta estimates are readily available

on

Finance Assignment

many finance web sites. For example, you can find beta estimates on most trading sites such

as Commsec and E*Trade.

It is NOT standard practice to simply take the beta estimate for your firm and plug it into the

CAPM. This is because beta estimates for individual firms are imprecise and have large

standard errors (i.e., they can be so contaminated by estimation error that they are

nonsensical). So, the usual practice is to take estimates from a number of comparable

companies (in the same industry) and then apply some judgment to convert the range of

estimates into a single value for use in the CAPM.

However, this is not quite as simple as it sounds. Although the “comparable” firms all have

the same inherent business risk (the asset beta), they will have different capital structures

(different mixes of debt and equity finance). So we need to control for differences in capital

structure, and this is done by the process of un-levering and re-levering.

The first stage is to estimate the asset beta from our first comparable firm as:

In practice, it is often assumed that the debt beta is equal to zero, so all you would need here

are estimates of and for the comparable firm. Note that there are some more

complicated formulas that are sometimes used for this step, depending on different

assumptions, but for the purposes of this assignment we’ll use the formula above for un-

levering and re-levering.

You then repeat this for a number of comparables, obtaining a number of estimates of the

asset beta. You then apply judgment to select a single value.

The second step is then re-levering to apply YOUR firm’s capital structure. Here, you use

the same formula, but you input your asset beta estimate and the capital structure for your

firm, and solve for the equity beta for your firm. This then goes into the CAPM to give an

estimate of the required return on equity.

In practice, if you have 24 good comparable firms, you would use them all. But for the

purposes of this assignment, repeating the same calculation over and over again doesn’t

make a lot of sense, so restrict the set of comparables to three or four firms. Bear in mind,

though, that it’s possible that you will get a wide range of asset beta estimates in this small

sample and have to apply a lot of “judgment.”

4. The market risk premium is usually based on a range of estimates. For example, a set of

recent estimates compiled by the Australian Energy Regulator is available at:

many finance web sites. For example, you can find beta estimates on most trading sites such

as Commsec and E*Trade.

It is NOT standard practice to simply take the beta estimate for your firm and plug it into the

CAPM. This is because beta estimates for individual firms are imprecise and have large

standard errors (i.e., they can be so contaminated by estimation error that they are

nonsensical). So, the usual practice is to take estimates from a number of comparable

companies (in the same industry) and then apply some judgment to convert the range of

estimates into a single value for use in the CAPM.

However, this is not quite as simple as it sounds. Although the “comparable” firms all have

the same inherent business risk (the asset beta), they will have different capital structures

(different mixes of debt and equity finance). So we need to control for differences in capital

structure, and this is done by the process of un-levering and re-levering.

The first stage is to estimate the asset beta from our first comparable firm as:

In practice, it is often assumed that the debt beta is equal to zero, so all you would need here

are estimates of and for the comparable firm. Note that there are some more

complicated formulas that are sometimes used for this step, depending on different

assumptions, but for the purposes of this assignment we’ll use the formula above for un-

levering and re-levering.

You then repeat this for a number of comparables, obtaining a number of estimates of the

asset beta. You then apply judgment to select a single value.

The second step is then re-levering to apply YOUR firm’s capital structure. Here, you use

the same formula, but you input your asset beta estimate and the capital structure for your

firm, and solve for the equity beta for your firm. This then goes into the CAPM to give an

estimate of the required return on equity.

In practice, if you have 24 good comparable firms, you would use them all. But for the

purposes of this assignment, repeating the same calculation over and over again doesn’t

make a lot of sense, so restrict the set of comparables to three or four firms. Bear in mind,

though, that it’s possible that you will get a wide range of asset beta estimates in this small

sample and have to apply a lot of “judgment.”

4. The market risk premium is usually based on a range of estimates. For example, a set of

recent estimates compiled by the Australian Energy Regulator is available at:

Finance Assignment

http://www.aer.gov.au/system/files/AER%20-%20Draft%20decision%20-

%20Powerlink%20transmission%20determination%20-%20Attachment%203%20-

%20Rate%20of%20return%20-%20September%202016.pdf

beginning on p. 3-104. You should comment on whether you agree with the AER’s

conclusions on the best current estimate of the MRP.

5. The corporate tax rate is usually estimated as the statutory rate, especially for firms that are

consistently profitable. Firms that have accumulated tax losses can offset those losses

against current profits, so their effective tax rate may be lower. But many companies are

consistently profitable and pay corporate tax every year, and for them the statutory rate is

usually used.

6. The required return on debt is usually estimated with reference to the firm’s credit rating. If

your firm has a BBB rating, you would need to find the current yield on BBB-rate corporate

bonds. This information is available from the RBA at:

http://www.rba.gov.au/statistics/tables/xls/f03hist.xls.

7. For the gamma parameter, there is the regulatory approach which is set out at:

http://www.aer.gov.au/system/files/AER%20-%20Draft%20decision%20-

%20Powerlink%20transmission%20determination%20-%20Attachment%204%20-

%20Value%20of%20imputation%20credits%20-%20September%202016.pdf

and there is commercial practice, which is summarised starting at p. 312 of the following

independent expert valuation report:

http://www.apa.com.au/media/223351/140407%20env%20scheme%20booklet%20approved

%20for%20despatch%20to%20shareholders.pdf

The deliverable for this project is a short WACC Review Report – a set of calculations and

recommendations for what the firm should adopt as its approved WACC estimate, for use in NPV

calculations for proposed new projects. Many firms would conduct such a review annually and fix a

WACC number, approved by the board, to be used as the NPV discount rate. Make sure you clearly

cite all sources.

http://www.aer.gov.au/system/files/AER%20-%20Draft%20decision%20-

%20Powerlink%20transmission%20determination%20-%20Attachment%203%20-

%20Rate%20of%20return%20-%20September%202016.pdf

beginning on p. 3-104. You should comment on whether you agree with the AER’s

conclusions on the best current estimate of the MRP.

5. The corporate tax rate is usually estimated as the statutory rate, especially for firms that are

consistently profitable. Firms that have accumulated tax losses can offset those losses

against current profits, so their effective tax rate may be lower. But many companies are

consistently profitable and pay corporate tax every year, and for them the statutory rate is

usually used.

6. The required return on debt is usually estimated with reference to the firm’s credit rating. If

your firm has a BBB rating, you would need to find the current yield on BBB-rate corporate

bonds. This information is available from the RBA at:

http://www.rba.gov.au/statistics/tables/xls/f03hist.xls.

7. For the gamma parameter, there is the regulatory approach which is set out at:

http://www.aer.gov.au/system/files/AER%20-%20Draft%20decision%20-

%20Powerlink%20transmission%20determination%20-%20Attachment%204%20-

%20Value%20of%20imputation%20credits%20-%20September%202016.pdf

and there is commercial practice, which is summarised starting at p. 312 of the following

independent expert valuation report:

http://www.apa.com.au/media/223351/140407%20env%20scheme%20booklet%20approved

%20for%20despatch%20to%20shareholders.pdf

The deliverable for this project is a short WACC Review Report – a set of calculations and

recommendations for what the firm should adopt as its approved WACC estimate, for use in NPV

calculations for proposed new projects. Many firms would conduct such a review annually and fix a

WACC number, approved by the board, to be used as the NPV discount rate. Make sure you clearly

cite all sources.

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