The purpose of the projects is to show some of the sources of measurement errors in financial analysis

WACC
Project

In this project, you will find and discern
the appropriate data to determine a realistic assessment of the weighted
average cost of capital for a firm of your choosing.
You will need to search for data from
several sources, use subjective judgment to determine which data to use or
discard, use subjective judgment to determine which calculation gives a more
acceptable estimate and make some simplifying assumptions.

The purpose of the projects is to show some
of the sources of measurement errors in financial analysis, to introduce the
diverse sources of publicly available financial information and to develop
skill in analysis in situations where there are too much or too little data.

Keep the following in mind when choosing a
company:

Publicly
traded
No
utilities
No
financial firms
No all
equity firms
No firms
with large amounts of convertible securities or warrants

Organization of the paper should be as
follows:

I.
Title page

II.
Table of Contents

III.
Introduction/Background (2-3
pages)

This section should include background on the company that has been
chosen.

IV.
Pages showing equations with
data and brief description

There is no page
length given for this as it can vary greatly. This section is to be divided up
based on the topics. In each section, you must show and explain the equations
that are used. In addition, you are to draw any conclusions on the company you
can from this data. Please note that detailed worksheets showing all of the
calculations for this section are to be included in an appendix.

·
Cost of Equity (Common Stock)
o
Beta from Regression and two Betas from
analysts
o
Beta
Chosen for CAPM and why
o
Capital
Assets Pricing Model (include how determined RF and[ RM or (RM – RF)]
o
Discounted
Cash Flow (DCF) (only if dividends – include how determined)
o
Own-Bond-Yield-plus-Judgmental-Risk-Premium
(include how determine risk premium)
·
Cost of Preferred Stock
·
Cost of Debt (make sure to
include table that lists all bond issues with weighted average cost of debt)
·
Market Value of Debt (will have
calculated above, but will need to add any long term leases from balance sheet to get total
market value of debt)
·
Market Value of Equity
·
Market Value of Preferred Stock
·
Value of Firm
·
Firm’s Tax Rate (explain how determined)
·
Weight for Equity
·
Weight for Preferred Stock
·
Weight for Debt
·
WACC (Weighted Average Cost of
Capital)
V.
Assumptions

Including but
not limited to RF, RM, RPM (which =Rm – RF),
growth rate of dividends. This page should have a brief description of
how you came up with the estimates with spreadsheets, etc. to be put in the
appendix.

VI.
Appendix

Appendix should include all relevant data
including debt data from Morningstar, calculations of weighted average cost of
debt, stock returns, betas from analysts, beta regression analysis, method/sourcing
for RFand RM,growth rates for dividends, different
methods to determine tax rates, etc. Detailed
descriptions, tables of data and excel sheets etc will be in the appendix.

VII.
References

HELPFUL EQUATIONS

WACC = [(wE)
x RE] + [(wPF) x RPF] + [(wD) x RD x (1- TC)]

Where:

Weights
(wE)
= % of common equity in capital structure
(wPF)
= % of preferred stock in capital structure
(wD)
= % of debt in capital structure
Component costs
RE = firm’s cost of equity
RPF = firm’s cost of preferred stock
RD
= firm’s cost of debt

TC
= firm’s corporate tax rate
HELPFUL INFORMATION

Useful information will be found in the
video, the sample Excel sheets, or your text’s tool kit Excel sheets. For
instance:

Bonds

You enter the ticker symbol about half way down on the
Morningstar bond page which you accessed by clicking on bonds on the first
page.
You will then see all the bonds for the company, in this case,
Southwest Airlines.
Copy and paste the information into an excel spreadsheet. You
may adapt the bond spreadsheet given to you, or show your calculations in
a new spreadsheet or show in another document

Calculating
the Weighted Average Cost of Debt

Find the
market value of each bond issue. To do this find the number of bonds and
then multiply by the price of the bond (remember that bond prices are
quoted in 100s, but are really 1000s).
If there
is no bond price, assume $1000 par is the price.
For
these bonds, the YTM =coupon rate
Calculate
the total market value of bonds
Calculate
the weights for each bond issue as market value of bond issue/ Total
market value of debt. Make sure your weights sum to one.
For each
bond issue, multiply the weight by that issue’s YTM.
Sum the
weighted YTMs, and you now have the weighted average RD,

Calculating the Weights for the WACC

MV of
bonds has already been calculated. To that you will add in the value of
leases from the Balance Sheet
For
Preferred Stock, find the number of preferred shares in the annual report
and the prices in the WSJ Market Center
For common
equity, find the price and number of shares in Yahoo Finance.
Can use
example found in bottom half of bond worksheet or develop your own.

Calculating
the Required Return on Preferred Stock

To
Calculate RPF, we use the constant dividend model, ie. the
perpetuity model.
RPF
= Dividend/P0
Check in
your company’s annual report to see if they have preferred stock and what
the dividend is. Make sure you use the yearly dividend since we are
calculating annual returns.

·
Prices can be found in the WSJ
Market Center: .wsj.com/mdc/public/page/2_3024-Preferreds.html”>http://online.wsj.com/mdc/public/page/2_3024-.wsj.com/mdc/public/page/2_3024-Preferreds.html”>Preferreds.html

Calculating
the Required Return on Common Stock

CAPM

Determining
Beta

Find the
beta from Yahoo Finance and Value line for your firm.

Perform
a regression using stock returns versus the appropriate market return.

For
most firms, the S&P 500 will be sufficient; if you chose a relatively small

firm,
you might want to use the NASDAQ returns.

EXAMPLE:
The example that
I show you uses IBM and 60 months of historical monthly price data. I also used
the monthly price data for the S&P 500.
This information
is downloaded first and then only the needed columns are cut and pasted into
the spreadsheet and the monthly returns will be automatically calculated.

Data on stock prices and
dividends can be downloaded from the web and used to make betas for real
companies. I demonstrate the process for
IBM in this section. I downloaded stock prices and dividends from
http://finance.yahoo.com for IBM using its ticker symbol IBM. I also downloaded
data for the S&P 500 Index, whose
symbol is ^GSPC to represent the market. Here are the steps I followed:

Steps:

Access the Internet, then go to .yahoo.com/”>http://finance.yahoo.com/
Enter IBM in the symbol slot and then
click Get quotes.
Click on “Historical prices”
to get a history of IBM prices.
Enter a Start Date 5 years ago and a
current ending date .
Click the “monthly” button.
then “Get prices” to get
5 years of monthly
prices for IBM. The closing
prices are adjusted for dividends and splits.
Note that Yahoo’s data is downloaded as
a CSV file. Save the file as an excel spreadsheet. Save as IBM
Repeat the process to get the S&P
index, symbol ^GSPC . Save this
file as SP500 and in excel format.
Open the IBM file and delete the
columns except for the date and closing prices. Then open the SP500 file,
copy the closing price data, and paste it into Column B on the IBM file.
Now move the IBM data over to column D
and then calculate the monthly returns on the market and on IBM
Now you can run the regression of IBM’s
returns on the market to find its beta

Regression
analysis is performed by following this command path: Tools => Data Analysis
=> Regression.

This will yield
the Regression input box. If Data
Analysis is not an option in your Tools menu, you will have to load that
program. Loading the Analysis ToolPak is
different in each version of Office so you will have to determine how to find
it. Once it is loaded, you will now be able to access Data Analysis. From this
point, you must designate the Y input range (stock returns) and the X input
range (market returns). You can have the
summary output placed in a new worksheet, or you can have it shown directly in
the worksheet, as I did, but be careful that you place it in a blank area of
your spreadsheet.

You may decide
that a years worth of weekly data would be better, perhaps if there were
something unusual two years ago. You could also use daily data, generally 200
days worth. In these cases you will have to adjust the spreadsheet for fewer/more
data points.

You must
now decide if you want to average your betas or drop one of them. In our
example , the calculated beta was .643 and we had two other estimates of
.66 and .85. It would be your choice to either drop the .85 and average
the other two, or average all three.

You must
justify your choices and provide citations in the body of your report and
references at the end.

You must now
decide what value you will use for RF and either RM or RPM where
o CAPM: RE = RRF + (RM
– RRF)b
= RRF + (RPM)b.

Again, You
must justify your choicesfor RF
and either RM or RPM
and provide citations in the body of your report and references at
the end.

The
Own-Bond-Yield-Plus-Judgmental-Risk-Premium Method

RE
= RD + Judgmental risk premium
This
judgmental-risk premium¹ the CAPM equity risk premium, RPM
Produces
ballpark estimate of RE
Useful
check, particularly if Dividend Growth and CAPM are significantly
different
Again,
you must justify your answer

Dividend
Growth Model

RE = {[D0* (1+g)] /P0 } + g
The challenge here is to estimate the growth rate. There are
several suggestions in your text as well as in earlier videos.

Corporate
Tax Rate

You may
be able to find the corporate tax rate directly in the annual report
Or you
can choose to use the formula

Taxes =
Tax Rate * Earnings Before Taxes

Since
both Taxes and Earnings before Taxes are in the Balance Sheet, you can
then calculate the tax rate

Reference

McDaniel, William (1997). The Cost of
Capital Project Journal of Financial
Education,
Fall 1997. p. 57-66.