Financial Analysis Exercise IV Part A: Weighted Average Cost of Capital (WACC) Here again is the formula for WACC. For simplicity the term for preferred stock has been removed: Go to http://thatswacc.com/ and enter the ticker symbol for the stock you selected and click on the tab entitled Calculate WACC. Complete the following tables: Name of Company/Stock Alcoa- INC Ticker Symbol AA From the http://thatswacc.com/ results for your company: WACC Cost of debt, iD Corporate tax rate, TC Total debt, D Total equity, E Total firm value, V Cost of equity, iE CAPM Components Beta, Historical market return, iM Assumed 11% Risk-free rate, iF Assumed 3% Using data in the table confirm the accuracy of the sites WACC calculation: Weight of Equity E/(E+D) Weighted Average Cost of Equity E/(E+D) iE Weight of Debt D/(E+D) Pre-Tax Weighted Average Cost of Debt D/(E+D) iD After-Tax Weighted Cost of Debt D/(E+D) iD (1- TC) Weighted Average Cost of Capital = E/(E+D) iE + D/(E+D) iD (1-Tc) Part B: Dividend Payout and Growth Ratios Recall from Module 1 the following two ratios: Internal growth rate = (ROA RR) / [1-(ROA RR)] (Eq. 3-30) where RR = Retention ratio = (Addition to retained earnings)/Net income (Eq. 3-31) The internal growth rate measures the amount of growth a firm can sustain if it uses only internal financing (retained earnings) to increase assets Sustainable growth rate = (ROE RR) / [1-(ROE RR)] (Eq. 3-33) If the firm uses retained earnings to support asset growth, the firms capital structure will change over time, i.e., the share of equity will increase relative to debt To maintain the same capital structure managers must use both debt and equity financing to support asset growth The sustainable growth rate measures the amount of growth a firm can achieve using internal equity and maintaining a constant debt ratio 1. For the firm selected for Part A, calculate its internal growth rate for the last fiscal year: = (ROA RR) / [1-(ROA RR)] = 2. Calculate the firms sustainable growth rate for the last fiscal year: = (ROE RR) / [1-(ROE RR)] = Part C. Consider your results for Parts A and B. If the chosen firm grows at its internal growth rate, increasing assets only with its retained earnings, how will this likely affect its WACC? Show calculations. If the chosen firm grows at its sustainable growth rate with increases in both its retained earnings and debt, maintaining a constant debt ratio, how will this affect its WACC? If the chosen firm attempts to grow faster than its sustainable growth rate with modest increases in its debt ratio, how will this likely affect its WACC? What about very large increases in its debt ratio? Explain. Appendix Should the Web site http://thatswacc.com/ not be available, please follow the instructions below that have been posted at http://thatswacc.com/faccs.php on how to calculate the terms in WACC. The components of the WACC equation are calculated using the following financial data: From the firms balance sheets: Period ending Last Fiscal Year Last Fiscal Year -1 Last Fiscal Year -2 Short term debt + Current portion of long term debt (CMLTD) Long Term Debt Total debt, D From the from the firms income statements: Period ending Last Fiscal Year Last Fiscal Year -1 Last Fiscal Year -2 Interest expense Income before tax Income tax Other data: Firms current market capitalization (intraday stock price shares outstanding) See below. Firms beta, See below. Return on the market, iM Assume 11% Risk-free rate, iF Assume 3% The calculations in the table are based on the following: Total debt, D, is the sum of Short term debt + CMLTD + Long Term Debt Total equity, E, is the firms current market capitalization = current stock price times the number of shares outstanding. [Should http://thatswacc.com/ not be available, Market capitalization is available on the Summary page at the Yahoo Finance (http://finance.yahoo.com/) site for the stock.] Total value of the firm, V, equals Total debt, D, + Total equity, E Cost of debt, iD, = Interest pd in most recent fiscal yr/(Sum of total debt in last two fiscal yrs/2) iD = Interest expense/Average debt Corporate tax, Tc, the firms corporate tax rate = Sum of prior three fiscal yrs Income tax expense/ Prior three yrs Income before tax TC = Average Tax Expense/Average Income Before Tax Firms cost of equity, In the table if is assumed to equal 0.03 and iM is assumed to equal 11%. [Should http://thatswacc.com/ not be available, the firms beta, E, is available on the Summary page at the Yahoo Finance (http://finance.yahoo.com/) site for the stock.]