finmgmt5
| FIN534 Week 5 Scenario Script: The Weighted Average Cost of Capital | ||
| Slide # | Scene/Interaction | Narration |
| Scene 1 | Intro slide | |
| Slide 2 | Scene 2
Wacc is pronounced like whack | FIN534_5_2_Joe-1: Hello, everyone. It has been awhile since we have seen each other! Long time no see everyone. My job has me out of the office more than usual, but I wanted to stop by and congratulate you on some fabulous work so far. You have been asked to do a lot of calculating as part of our financial analysis regarding our current state at TFC and the expansion project. I can see that your Strayer University education is paying off. They are really preparing you for making informed business decisions. FIN534_5_2_Joe-2: I brought some snacks and refreshments; help yourself. They are in the break-room. At TFC we encourage our employees to work out but that does not mean you cannot have some snacks. It just means you will have to work out a little more at the gym later. (laughter) FIN534_5_2_Joe-3: Well, I have to go. I have a busy day - full of meetings, but before I leave I would like you to continue your financial analysis. First, I would like you to do some research on financial options as we may be interested in using some of our cash to invest in those financial vehicles. Secondly, I would like you to determine our WACC, or weighted average cost of capital. Good luck and I’m excited to see the reports on my desk. FIN534_5_2_Joe-4: Have a great day! You are the best financial team in the world! |
| Slide 3 | Scene 3
| FIN534_5_3_Don-1: Joe is the most energetic and positive-minded CEO on the planet. He gave us some tall orders but, I am confident you and Linda will complete them with the highest standards. FIN534_5_3_Linda-1: Yes Don, we will. Our first task is to review what our financial options are in case we want to go down that investment road in the future. I have always learned that the more you are prepared ahead of time, the better the decision making is.
FIN534_5_3_Don-2: I agree, Linda. That is why we have you and your Intern on this highly visible project. We want to make sure we are going to make the best practical decision for TFC. I will leave you two now so you can start preparing. FIN534_5_3_Linda-2: Let us meet in the conference room. I will meet you there. I want to pick up some of my textbooks dealing with financial options. |
| Slide 4 | Scene 4
| FIN534_5_4_Linda-1: Here we are back in what I am now calling the “Financial Management Room”. I was able to find some text books on financial options. They are the part of investing that I like to call “The Great Unknown.”; because you are taking a chance on how stock will react in the future. An option is basically an investor’s choice to buy or sell a particular security at a predetermined price in the future and within the certain time period. For example, you may only have ninety days to have the option of buying a share of stock at an already agreed upon price. Also, options are traded on an options exchange market just like stocks are traded on a stock exchange market. |
| Slide 5 | Scene 5
| FIN534_5_5_Linda-1: The two types of options that we are going to look at are the Call Option and Put Option. FIN534_5_5_Linda-2: With a Call Option, the holder of the option is given the right to buy a share of stock at a predetermined price within a certain period. If the owner decides to buy the share, then it is exercised. The predetermined price is called the strike or exercised price, because that is the agreed upon price and it is only carried out if the owner strikes a deal. FIN534_5_5_Linda-3: Let us look at an example. If someone buys a call option for two dollars and it comes with the terms of a strike price of thirty dollars a share with an expiration date of six months, the owner has six months to buy a share of stock at thirty dollars. If the stock is currently selling for twenty dollars, the owner would not exercise that option as the strike price is greater than the trading price. However, if the trading price goes over thirty dollars, actually thirty two since the owner paid two dollars for the option, then the owner has to decide if the option should be exercised. In our example, if the trading price is forty dollars then the owner should exercise the option as the share can be bought for thirty dollars. Whenever there is a profit involved, meaning that the stock price is greater than the exercised price, the option is said to be “in-the-money.” In our example, the owner would be “in-the money.” When the owner is “out-of-the-money”, that is when the exercised price is greater than the current price; the owner would not want to go through with the transaction. Of course for either transaction, you need to also consider the price you paid for such an option. FIN534_5_5_Linda-4: Personally, I like to think of the Call Option as the “High Rise” option, as the higher the share price goes the better as the owner is locked into a price. Keep in mind that most options come with an expiration date, meaning that if the owner does not exercise it within a certain period of time, the option is no good. |
| Slide 6 | Scene 6
| FIN534_5_6_Linda-1: The second type of option can be thought of as the exact opposite of the Call Option. It is the Put Option. This option gives the owner the right to sell a share of stock at a predetermined price. An owner would most likely execute this when the price of a share of stock falls below the exercised price, and of course the price paid for the put option. FIN534_5_6_Linda-2: Let us look at another example but this time with put options. If an investor buys a put option for one dollar at an exercised price of forty dollars and the stock is currently selling for fifty dollars, the investor would not exercise the option as the selling price is higher than the exercised price. In that case it would be better for the investor to sell a share of the company at fifty dollars if the owner has shares of it. FIN534_5_6_Linda-3: Now, let’s go back to our example. If the share price of the stock drops to ten dollars a share, the investor can exercise the put option at the price of forty dollars. Even though the share price is only ten dollars the investor would get forty dollars. Like the Call Option, the Put Option usually comes with an expiration date. FIN534_5_6_Linda-4: The difference with the Put Option is the owner is taking a risk that the price of the stock will go down. FIN534_5_6_Linda-5: As you can see, futures trading has risk involved. The owner of the option is taking a chance on what the price will be in the future, whether higher or lower than when the option was purchased. If the stock does not move in the direction you are hoping, then you stand the chance of losing money. (Phone rings) FIN534_5_6_Linda-6: Hello. Okay I will be right over. (Hangs up) FIN534_5_6_Linda-7: That was Don. He wants me to come by and pick up the information he has for our second task, calculating TFC’s weighted average cost of capital or WACC. In the meantime, can you do some decision making on options so we can put it in our report to Joe? I will see you later. |
| Slide 7 | Scene 7 Check Your Understanding: Linda would like you to complete make some determinations on call and put options. Please selected the best choice If an investor purchases a call option on a particular stock today, what is the investor is hoping the stock price will do? a) Price will go up? – Correct! The owner is hoping the price will go up as the call option provides for a fixed purchase price. If the fixed purchased price is less than the stock price, the owner will have a gain on the investment when executed. b) Price will stay the same? Nice try, but stock price volatility can provide for a gain or loss on an investment c) Price will go down? Nice try, but if the price goes down the investor will not be able to execute the option as the option will cost more than what the open market is asking If an investor purchases a put option on a particular stock today, what is the investor is hoping the stock price will do? a) Price will go down? – Correct! The owner is hoping the price will go down as the put option provides for a fixed selling price. If the fixed selling price is more than the stock price, the owner will not lose as much b) Price will stay the same? Nice try, but stock price volatility can provide for a gain or loss on an investment c) Price will go up? Nice try, but if the price goes up the investor will not be able to execute the option as investors will be able to sell their securities for more than what the put option is worth | |
| Slide 8 | Scene 8
WACC = wdrd(1-T) + wstdrstd(1-T)+wpsrps+wsrs Wacc is pronounced like whack
| FIN534_5_8_Linda-1: Great work! While we are not too familiar with options at TFC, it is always good to increase your knowledge base. This may be an investment choice for us later. FIN534_5_8_Linda-2: Now for our second task. The company wants us to calculate TFC’s Weighted Cost of Capital, more commonly known as the WACC. FIN534_5_8_Linda-3: The WACC includes many of the rates we have calculated earlier. It is like bringing the pieces together in a puzzle. FIN534_5_8_Linda-4: The formula to calculate the WACC is: Weight of debt times coupon rate of debt times one minus the tax rate plus weight of short term debt times interest rate on short term debt times one minus the tax rate plus weight of preferred stock times required return on preferred stock plus weight of common stock times required return on common stock. |
| Slide 9 | Scene 9 –
| FIN534_5_9_Linda-1: As we have done before, let us look at each component of the WACC. FIN534_5_9_Linda-2: The first component is the r sub d, which is the Before-Tax Cost of Long Term Debt. While there can be many different ways to determine this debt, we will consider it to be the coupon rate that we plan on issuing for long term bonds. Previously, we determined that rate to be eight percent. FIN534_5_9_Linda-3: As the WACC suggests, we have to make an adjustment for the tax rate. This is because interest paid is deductible on the income statement for TFC, so in essence we are saving on taxes being paid. Think of it this way, since interest expense is deductible, TFC is already saving the tax rate on its bonds, so the rate being paid is really one minus the tax rate. For us, we are paying eight percent on our bonds and our tax rate is forty percent. FIN534_5_9_Linda-4: And the short term component of cost of debt is handled the same way. Let’s move back to the conference room to meet up with Don. |
| Slide 10 | Scene 10
| FIN534_5_10_Don-1: Another component of the WACC is the required rate of return on preferred stock. While TFC has never issued preferred stock, it is important to note should we ever decide. Preferred Stock is different than Common Stock, as it usually pays a better dividend than Common Stock and it is higher up on the order of being paid should a company decide to liquidate assets. To determine the required rate on preferred stock, the dividend divided by the price per share times one minus the flotation cost would be used. Flotation costs are those costs that are paid by the company who issues stock, like TFC, to an investment banking company, the company who would handle all of the transactions for the new offering. These costs need to be included in the calculation as the WACC is used to help determine the cost of raising new capital. Any new stock would have floatation costs included. For example, if we want to issue new shares of stock at one hundred dollars a share, and investment banking firm would handle the new issue for us. They would charge a fee. If they charge five percent of the offering price, in this case one hundred dollars, we would only get ninety-five dollars for each share sold and the five dollars would go to the investment banking company for taking care of the new issue. Bottom line is it costs money to issue new shares, |
| Slide 11 | Scene 11
| FIN534_5_11_Linda-1: The last component is the required rate of return on common stock or r sub s. For this component we use the CAPM as our required rate of return for common stock. Typically, when doing a project that involves an equity contribution, a company would first look at using their retained earnings. After they are used up, they would look at selling stock. The main reason is retained earnings do not have flotation costs which will result in a lower overall cost of equity for a company. Previously we calculated our CAPM to be fifteen percent. |
| Slide 12 | Scene 12
| FIN534_5_12_Linda-1: Now that we have all the components to the WACC, we are still missing one critical piece. And that is, how are we going to raise the capital? We know it will be through issuing bonds and selling stock, but what percentage of each. Or better yet, what weighted percentages will be assigned to each component? These are the ”W’s” on our WACC formula. FIN534_5_12_Don-1: Linda that is an excellent point. We have the components but the weights come from what we at TFC feels is our optional capital structure and then keep that in mind when we are trying to raise new capital. While it is a work in progress, we feel that our optimal capital structure is sixty percent equity and forty percent debt. We also do not plan on issuing any preferred stock and all of our debt will be long term debt. FIN534_5_12_Linda-2: Well, now it is time to put all the pieces together. |
| Slide 13 | Scene 13 Check Your Understanding – From the information given in prior scenes what would TFC’s WACC be? WACC = wdrd(1-T) + wstdrstd(1-T)+wpsrps+wsrs .40*.08*.60 + .60*.15 Answer = 10.92% If get wrong, good try but remember WACC = wdrd(1-T) + wstdrstd(1-T)+wpsrps+wsrs Also, with weights being .40 for bonds and .60 for stocks. There is no short term debt or preferred stock | |
| Slide 14 | Scene 14
| FIN534_5_14_Linda-1: Great work. The ten and ninety-two hundredths percent tells us what the cost of raising new capital will be for our company. In order for us to proceed with a project, we have to make sure the return will be at least ten and ninety-two hundredths percent or we should not do the project. This WACC can be used to help us value our operations as it can be used as the discount factor for future cash flows. FIN534_5_14_Linda-2: There are many factors and assumptions that went into deriving the WACC. That is why it is important that we are confident in our analysis. We can also do situational analysis here and consider a different optimal capital structure or required rates of return. FIN534_5_14_Linda-3: This was a lot of work and now it is time to work off those extra calories from our mini celebration by Joe. Let us go to the pool for a swim. But before we go to the pool, let’s stop by Don’s office to invite him to the pool and to review what we covered today.
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| Slide 15 | Scene 15
| FIN534_5_15_Don-1: You both did much work on this assignment. The two main areas were financial options and the WACC. While different, they both are needed for decision making. FIN534_5_15_Don-2: We first looked at some financial options and learned what they were and when they should be exercised. We then learned that call options are bought in hopes that a company stock will go up while put options are the opposite. FIN534_5_15_Don-3: The WACC is thought of as the cost of a project to a company. Just like diversifying an investment portfolio, a company should also look at different options when raising capital. The two common components are debt and equity. The optimal capital structure will assign a percent to each component which will be used in calculating the WACC. FIN534_5_15_Don-4: Great work by the two of you. I already know your next assignment. It has to do with cash flow. I will fill you in later. Now it is time to start burning off those calories. (laughter) |
| Slide 16 | Scene 16
| Closing slide |
