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Background:
• Reference Brigham, Eugene F., and Ehrhardt, Michael, C., Financial Management, Theory and Practice, 14th Edition (2013). Chapter 15, Formula (15-2, p. 591), Hamada equations (15-9, 15-10, pp.610-611), & the process described on pages 608 through 614, plus graph on page 612 (Figure 15-7) are the “keys” to trying to determine the “optimal WACC.”
• The precise identification of the firm’s optimal capitalization structure is difficult, and depends a great deal on judgment of corporate officials and investment experts, as well as on the quality of data used in numerical calculations. Bottom-line is: only your study team can possibly know the “optimal WACC” for your selected company…and, it may not make that much of a difference in maximization of stockholder wealth from today’s “target WACC.”
Assumptions/”Givens”
• For the purpose of the project, assume no preferred stock.
• Similar to the textbook on pages 608-611, we will assume a zero percent (0.0%) growth rate in your company. (Otherwise, you will have to figure out future capital investments, and make adjustments in the “free cash flow (FCF)” calculations).
• For your target WACC, you will have determined what today’s cost of debt is for your company (usually, from existing corporate balance sheets or annual reports, or both). Now, for lower or higher amounts of debt, you have to (somehow) determine the costs of debt as the debt/equity ratio is changed. The textbook (Table 15-5, p. 610) illustrates this process for you. Rather than each team having to spend a lot of time visiting/calling bankers, we will use the following as “givens” for you:
o For each decrement or increment of 10% from your target ratio of debt and the corresponding debt costs, the debt costs decrease/increase by 10% from the target.
o For each decrement or increment of 20% from your target ratio of debt and the corresponding debt costs, the debt costs decrease/increase by 25% from the target.
o For each decrement or increment of 40% from your target ratio of debt and the corresponding debt costs, the debt costs decrease/increase by 60% from the target.
| Subject | Business | Pages | 7 | Style | APA |
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Answer
Weighted Average Cost of Capital (WACC)
The company which has been chosen in this case is Apple Limited Company. The financial statement of the trading year ending 30th December 2018.
Weighted Average Cost of Capital (WACC) refers to calculation of a firm’s cost of capital in which each category of capital is proportionately weighted. All sources of capital, including stock, preferred stock, bonds, and any other long -term, debt are included in the calculation of WACC. With the information provided, in the financial statements of Apple Limited Company, it is possible to calculate the following variables;
Equity is calculated as follows;
Total assets – long term debt
= 365,725- 93,735
= 271,990
Debt to equity ratio therefore is as follows;
93,735/ 271,990
= 0.345 or 34.5%
The current debt/ equity ratio for Apple Limited company has been calculated and found to be 34.5%. Using the guidelines which have been given for the project, the following values have been calculated:
Debt/Equity Ratio Costs of Debt (rd)
3.5% ----------------------- lower target rate by 60% ---------------------------------------- 1.4%
10.5% ----------------------- lower target rate by 25% ----------------------------------------1.5%
20.5% --------------------- lower target rate by 10% ---------------------------------------4.45%
34.5% --------------------- target WACC debt costs found by team (before tax) -------- 2.45%
44.5% --------------------- increase rate by 10% -------------------------------------------2.78%
54.5%% --------------------- increase rate by 25% -------------------------------------------4.94%
64.5% --------------------- increase rate by 60% ------------------------------------------- 5.81%
Tax rate in Apple Limited Company during the financial year ending 2018 was found to be 20%
|
% of Debt/Equity Ratio |
Cost of Debt |
After-Tax Cost of Debt |
Beta Coefficient |
Common Stock Cost |
WAAC |
|
3.5% |
1.4% |
1.12% |
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10.5% |
1.5% |
1.20% |
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20.5% |
4.45% |
3.56% |
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34.5% |
2.45% |
1.96% |
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44.5% |
2.78% |
2.22% |
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54.5% |
4.94% |
3.95% |
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64.5% |
5.81% |
4.65% |
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NB: The blanks spaces are for figures to be calculated.
Before the Weighted Average Cost of Capital (WACC) is calculated, the cost of equity has to be calculated. The value of beta for Apple Company was found to be 1.23. The cost of equity is therefore calculated as follows;
Cost of equity = (rs) =
Cost of Equity (rs) = 3% + 1.23(7.5%) = 0.39225
WAAC = wd (1-T) rd + wsrs
= 34.5% (1-0.20)2.450% + (46.1%) (3.923%)
= (34.5%) (1.96%) + (46.1%) (3.923%)
= 0.00672+ 0.0181
= 2.48%
Therefore, the target WACC = 0. 00672+ 0. 181
= 0.0248 or 2.48%
In order to calculate the un-levered beta using the Hamada equation, the following steps are followed, on the basis of the following formula;
Hamada Equation = bU = b/ [1+ (1-T) (wd/ws)
Therefore,
bU =1.23/ [1+(1- 0.20) (34.5%/ 46.1%)]
= 1.23[1+(0.80) (3.0701)]
= 1.23(0.159)
= 0.1956 or 19.56%
After calculating bU, it is possible to calculate the other beta coefficients for all of the set values:
|
% of Debt/Equity Ratio |
Beta Coefficient |
Common Stock Cost (rs) |
|
|
|
|
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0.00% |
0.20 |
3% + 0.20 (7.5%) = 4.5 |
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3.5% |
0.20((1+(1-0.20) (3.5/97.55)) = 0.21 |
3% + 0.21 (7.5%) = 4.6% |
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10.5% |
0.20((1-(1-0.20) (10.5/87.55)) = 0.22 |
3% + 0.22 (7.5%) = 4.7% |
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20.5% |
0.20((1-(1-0.20) (20.5/77.55)) = 0.24 |
3% + 0.24(7.5%) = 4.87% |
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34.5% |
0.20 ((1-(1-0.20) (34.5/67.55)) = 0.28 |
3% + 0.28(7.5%) = 5.1% |
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44.5% |
0.20((1-(1-0.20) (44.5/57.55)) = 0.32 |
3% + 0.32 (7.5%) = 5.4% |
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54.5% |
0.20((1-(1-0.20) (54.5)/47.55)) = 0.38 |
3% + 0.38(7.5%) = 5.9% |
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64.5% |
0.20 ((1-(1-20) (64.5/37.55)) = 0.47 |
3% + 0.47 (7.5%) = 6.5% |
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The Final WACC Calculation is done as follows;
|
% of Debt/Equity Ratio |
After-Tax Cost of Debt (rd) |
Common Stock Cost (rs) |
WACC = wd (rd)(1-T) + ws (rs) (%) |
|
0.00% |
N. A |
3.94% |
0 + 100(3.94%) = 3.94% |
|
3.5% |
1.12% |
4.01% |
0.035 (1.12%) + 0.9755(4.01%) = 3.95% |
|
10.5% |
1.20% |
4.71% |
0.1050(1.20%) + 0.8755(4.71%) = 4.25% |
|
20.5% |
3.56% |
9.71% |
0.205(3.56%) + 0. 7755(9.71%) = 8.26% |
|
34.5% |
1.96% |
12.21% |
0.345(1.96%) + 0.6755(12.21%) = 8.92% |
|
44.5% |
2.22% |
14.71% |
0.445(2.22%) + 0.5755(14.71%) = 9.45% |
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54.5% |
3.95% |
17.21% |
0.545(3.95%) + 0.4755(17.21%) = 10.34% |
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65.5% |
4.65% |
18.24% |
0.655(4.65%) + 0.3755(18.24%) = 9.90% |
Conclusion
The target capitalization structure which has initially been thought to be 34.5% is not accurate target capitalization structure for Apple Limited Company. As per the calculation done, the company’s target capitalization structure instead is 44.5% debt equity is 57.55 while the Weighted Average Cost of Capital (WACC) is 2.48%. the graph below summarizes the beta trend summarized in the above calculations.
With the information which are evident in the graph, as well as theories concerning the stockholder wealth maximization which have been taught in class, I would recommend that Apple Limited to move its WACC level to 5.6% % and debt 25.5% of the equity.
References
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The Apple Company. (2019). 2018 Annual Report on Form 10-K. Retrieved from: http://www.annualreports.com/HostedData/AnnualReports/PDF/NASDAQ_AAPL_2018.pdf. Yahoo! Finance. (2019, July 4). The Apple Limited Company. Retrieved from: https://finance.yahoo.com/quote/AAPL/.
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