Financial Analysis: WACC, Capital Budgeting, and Leasing Decisions

This assignment provides a detailed solution to a finance problem. The first part calculates the book and market values of debt, equity, and the company, followed by WACC calculations using both book and market values. The assignment then analyzes the relevance of market versus book value weights in WACC calculations. The second part of the assignment addresses a capital budgeting problem, comparing the options of buying versus leasing equipment. It includes calculations for depreciation, terminal cash flow, and net present value (NPV) for both options, ultimately determining the most financially beneficial decision for the company. The solution also discusses the key differences between leasing and borrowing.

Question 1
Solution 1
a) Book value of debt
=Book value of bond 1+ Book value of bond 2
=860,000,000+1,270,000,000
=2,130,000,000
b) Book value of equity
=BV of equity per share * Outstanding shares
=12.15*141900000
= 1,724,085,000
c) Book value of the company
= Book value of debt + Book value of equity
=2,130,000,000+1,724,085,000
=3,854,085,000
d) Market value of debt
=Face value * price at par
=Market value of bond 1+ Market value of bond 2
=860,000,000*0.94347+1,270,000,000*0.96643
= 2,038,750,300

e) Market value of equity
=Stock Price * Outstanding shares
=78.56*141900000
= 11,147,664,000
f) Market value of company
= Market value of debt + Market value of equity
=2,038,750,300+11,147,664,000
= 13,186,394,300.00
Solution 2
a) WACC using Book Value
WACC =Weight Debt * cost of debt *(1 – T) + Weight equity *cost of equity (Lumen
Learning Courses, 2019)
Weight Debt
=2,130,000,000/3,854,085,000= 55.27%
Weight Equity
= 1,724,085,000/3,854,085,000 =44.73%
Cost of Debt
=39.80%*3.045%+60.20%*2.965% =2.997%
Cost of equity using CAPM
Re = Rf+ Beta*(Rm –Rf)
=0.03%+1.380*7.5%

=10.38%
WACC=55.27%*2.997%*(1-30%)+44.73%*10.38%
= 5.8%
b) WACC using market value
WACC =Weight Debt * cost of debt *(1 – T) + Weight equity *cost of equity+
Weight Debt (Lumen Learning Courses, 2019)
=2,038,750,300/13,186,394,300= 15.46%
Weight Equity
=11,147,664,000/13,186,394,300=84.54%
Cost of Debt
=39.80%*3.045%+60.20%*2.965% =2.997%
Cost of equity using CAPM
Re = Rf+ Beta*(Rm –Rf)
=0.03%+1.380*7.5%
=10.38%
WACC=15.46%*2.997%*(1-30%)+84.54%*10.38%
= 9.1%

Solution 2
Market versus Book value weights
From above, the Book value WACC is different from the Market value WACC. This is because in the
former, the WACC is determined using Book value weights, whereas Market Value WACC is determined
using the market value of the company’s source of capital.
Book value is the value of an asset according to the balances of the asset shown on the company’s
annual financial statement (EFINANCE, 2019). On the other hand, the market value is the true
underlying value of the asset i.e. the price at which an asset would trade within the market (Lumen
Learning Courses, 2019). It is more or less the values of the book value and usually varies depending on
the time of the transaction (Wall Street Mojo).
Usually, when calculating the WACC or cost of capital, the market value weights are preferred over the
book value weights. The reason for this is investors demand a market required rate of return on the
market value of the capital and not on the book value of the capital (EFINANCE, 2019).
Secondly, the usage of market value weights in calculating WACC takes into consideration the returns
and risks of the businesses current environment (Lumen Learning Courses, 2019). For example, should
the company use the book value weights , they are at risk of making sub-optimal investment decisions
during investment appraisals. For example the WACC may be too low such that the business may accept
projects which are not feasible to the company (Lumen Learning Courses, 2019).
Book value weights should only be used to determine WACC if the market value of the sources of capital
are not available, otherwise Market value sources should always be used (Lumen Learning Courses,
2019).

Question 2
Solution 1
Project’s initial, (Year0) cash flows- $3,600,000
3 year MACRS Depreciation Table
Year Depreciation Rate Depreciation Expense
1 33.33% 1,198,800
2 44.45% 1,600,200
3 14.81% 533,160
4 7.41% 266,760
Book value at year 4
=market value- Depreciation expense
=3,600,000 – Depreciation expense = $1,080
Project’s Terminal (Year 4) cash flow after Tax
= market value -Tax*(Market value – book value)
=440,000-35%*(440,000-1,080)
=$286,378
Cost of capital
Cost of debt= yield *(1-tax rate) = 11%*(1-35%) = 7.15%
Option 1 : Buying Equipment
General assumptions
Initial (depreciable) investment $3,600,000
Income tax rate 35%
Discount rate 7.150%
Market value year 4 $440,000
Book value year 4 $1,080

Annual Net Cash Flow Estimates 0 1 2 3 4
Investment in fixed assets -
$3,600,000 $0 $0 $0 $0
Terminal Cash flow (After Tax) $0 $0 $0 $0 $286,378
Net income $0 -$779,220 -$1,040,130 -$346,554 -$173,394
Add back depreciation (non-cash expense) $0 $1,198,800 $1,600,200 $533,160 $266,760
Net cash flows during forecast period -
$3,600,000 $419,580 $560,070 $186,606 $379,744
Net Present Value (NPV) (2,280,827)
Option 2: Leasing Equipment
General assumptions
Initial (depreciable) investment $3,600,000
Annual investment $925,000
Refundable Security Deposit $210,000
Income tax rate 35%
Discount rate 7.150%
Market value year 4 $440,000
Book value year 4 $1,080
Annual Net Cash Flow Estimates 0 1 2 3 4
Investment in fixed assets -$1,135,000 -$925,000 -$925,000 -$925,000 $210,000
Terminal Cash flow (After Tax) $0 $0 $0 $0 $286,378
Net income $0 $0 $0 $0 $0
Add back depreciation (non-cash expense) $0 $0 $0 $0 $0
Net cash flows during forecast period
-$1,135,000
-$925,000 -$925,000 -$925,000 $1,756,00
0
Net Present Value (NPV) (2,223,697)
Buy or lease the equipment
Given that the NPV under the leasing option is higher than the NPV under buying the equipment, then
Warf is better off leasing the equipment. However, it is also important to note that both NPV are
negative. Therefore, unless Warf has increased revenues from this equipment, then the project may not
be feasible either way.
What are the key differences between leasing and borrowing? Are they perfect substitutes?
 Under leasing, the regular payments are fully tax-deductible. However, under borrowing, the
interest portion of the loan will only be tax deductible (Quick Books, 2019).

 Under leasing, the lessee does not own the asset hence cannot obtain a title to the asset until
the end of the lease. Under borrowing, the borrower owns the asset.
 Under leasing, since they do not own the asset, the asset cannot be depreciated for tax
purposes. Under borrowing, the owner can depreciate the asset.
 Due to the above differences, the two are perfect substitutes despite being fixed contracts that
reduce debt (Deloof & Verschueren, 1999)
References
Deloof, M., & Verschueren, I. (1999). Are Leases and Debt Substitutes? Evidence from Belgian Firms .
Financial Management Vol. 28, No. 2 , 91-95 .
EFINANCE. (2019). Market vs. Book Value WACC. Retrieved from
https://efinancemanagement.com/investment-decisions/market-vs-book-value-wacc
Lumen Learning Courses. (2019). The WACC. Retrieved from
https://courses.lumenlearning.com/boundless-finance/chapter/the-wacc/
Quick Books. (2019). Pros and Cons of Leasing vs. Buying Equipment. Retrieved from
https://quickbooks.intuit.com/r/office-and-equipment/pros-cons-leasing-vs-buying-equipment/
Wall Street Mojo. (n.d.). Book Value vs Market Value Differences. Retrieved from 2019:
https://www.wallstreetmojo.com/book-value-vs-market-value/