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Question Title:
The Cost of Capital: Principles and Practice
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<b><br> </b> </p> <p><b>Executive Summary</b> </p> <p>Sue Pane the chief executive at American bakery giant Tasty Bread has interest in a major expansion into this business. There has been developed a financial analysis by the forecasting team and based on this analysis Sue Pane forecasted that Tasty Bread requires an initial investment of $250 for the expansion of the business to produce jams and jellies and as a result of this investment it will generate a return of 7.5% by coming 10 years. When making expansion into their business Tasty Bread needs funds for investments. These funds can be procured from different types of investors, equity investors and debt investors, etc. These investors while providing the funds to the firm will have an expectation of receiving a minimum return from the firm. This expected return of 7.5% by the investors depends upon the risk-appetite of the investors and also on the characteristics of the Tasty Bread. This expected return required by the investors is cost of capital for Tasty Bread. In order to evaluate expected return it is recommended for Pane to not only set a benchmark return but also estimate the cost of capital, determine the capital structure weights as well as additional considerations to estimate cost of capital at Tasty Bakery. While making investment decisions, it is recommended for Tasty Bread to choose that alternative which generates at least that much return which is expected by the investors of the firm. Otherwise, the firm will not take up that alternative. In order to maximize the value of the firm, the cost of all the different sources of the funds must be minimized (Watson, & Head, 2016). It is also proposed for the XXXXX Bread to XXX a XXXXXXXXXX of XXXXXXXXXX XXXXX in order XX XXXXXX XXX XXXXXXXXXX error XXXXXXXXXX with XXXXXXXXXX XXXX estimates XXX X.0% XXXX of XXXXXXX is XXXXXXXX XX XXX XXXXXXXXXXX XXXXXXXX for Tasty XXXXX based XX the XXXX of XXXXXXX XXXXXXXXX of XXX comparable XXXXX XXXXXX XXXX its own XXXX XX XXXXXXX. </p> <p> </p> <p><b>XXXXXXXXX & Estimating XXX XXXX of XXXXXXX XX XXXXX XXXXX</b> </p> <p>XX estimate XXX XXXX of capital at XXXXX Bread XXXXX has XXXX XXXX a risk XXXXXXXX XX the XXX Torrada, a XXXXXX XX forecasting team, regarding the return data XXX 3 XXXXXXXXXX public sector firm in the XXX and jelly business XXXX as XXXXX River, XXXXX Oak and sugarloaf Mountain XXX it was accessed that the risk XXXXXXXXXX with the returns XX XXXXX XXXXX was XXXXXXX to XXXX he expected for the returns XX the XXXXXXXX. </p> <p><b><i>Estimate XXX XXXX of Debt XXX XXXXXX</i></b> </p> <p>Torrada XXXXXXXXX XXX XXXXXXXX return XXX XXXXXX and XXXX in XXXX XXXX to XXXXXXXX XXX XXXXXXXX returns XXX X XXXXXXXXXX XXXXX. XXX XXXXXXXXX XXXXXXXXXX XXX XXXXX to XXX XXX analyst in appropriately XXXXXXXXXX the XXXX XX XXXX. </p> <p><i>XXXXXXXXX 1: </i>Good XXXX-of-debt measures XXXXXXXX the XXXXXXXXXX risk XXXXXXX of debt XX XXXXXXXXXX XXXX. </p> <p><i>Principle X: </i>XXXX XXXX-of-XXXX measures are XXXX XXXXXXXXX XXXX matching XXX XXXXXXXXXXXXXXX XX XXX XXXXXXXXXXX XXXXX evaluated XXXX the characteristics XX the XXXXXXXX’s XXXXXXXXXX XXXX securities. </p> <p><i>Principle 3: </i>Good XXXX-XX-debt measures focus XX the opportunity XXXX for debt holders today. </p> <p>XXXXXX XX White Oak has been financed through XXXX XXX equity, the returns those XXXXXXX XXXXXXXXX XXXX divided among XXXXXX as well as debt holders. According XX XXXXXXXXX XXXXX 1 XXX return required by the equity holders (X.X%) is substantially XXXXXX XXXX the XXXXXX XXXXXXXX XX XXX debt XXXXXXX (5.0%) since the XXXX for the equity XXXXXXX is XXXXXX XX XXXXXXX to XXX XXXX for XXX XXXX holders. Because, debt holders XXXXXXXXXX the XXXXX claim on the returns that's XXX their risk XXX lower than equity XXXXXXX. The weighted XXXXXXX required XXXXXX XX XXXX and equity holders XXXXX to XXX XXXXXXXX XXXXXX XX the assets return since XXXX holders XXX XXXXXX XXXXXXX combine to obtain the overall assets XXXXXXX. XX simple XXXXX, the XXXX of capital for the XXXX assets XX XXXXX XX XXX XXXX for the XXXXXXX types XX XXXXXXXXX. </p> <p>The XXXXXX XX Sugarloaf XXXXXXXX XXX XXXXXXXX entirely XXXXXXX XXXXXX claims since it XXX no debt. XXXXXXXXXXXX, XXX XXXX of XXXXXX (8.2%) XXXXXXXX an estimate of XXX XXXX XX XXXXXXX, since XXX XXXXXX is XXX XXXX source XX XXXXXXX. XX XXXXXXXXXXXXXX, the required return or cost of XXXXXXX XXX XXXXXXXXX Mountain investments XX XXXXXXXX using Torrada’s estimate of Sugarloaf Mountain’s XXXX of equity, X.X% (Michael,XXXX). </p> <p><b><i>XXXXXXXXXXX XXX XXXXXXX Structure Weights of XXXXX XXXXX</i></b> </p> <p>In assigning weights XX debt XXX equity, it is XXXXXXXXX XX ensure that they should reflect the values XXXXXXXXX XXXX XXXXXXXX. XX is preferable to use the optimal capital structure XXXXXXX in estimating the cost XX capital and it is XXXXXXXXXXXXX XX XXXXXX XXX XXXXXXX if it XXX an inappropriate capital XXXXXXXXX. In order XX XXXXXX a WACC XXX XXX XXXXXX in the firm he used a XXXXXXXX XXXXXXX of estimates. The Table 1 shows the XXXXXXXXXXXX of XXXX XXXXXXXXXX. </p> <p><b>(Table X) WACC estimation</b> </p> <table> <tbody><tr> <td> <p> </p></td><td> <p>XXXXXXXXX XXXXXXXX </p></td><td> <p>White XXX </p></td><td> <p>Moose River </p></td></tr> <tr> <td> <p>Cost XX XXXX (XXXXXX) </p></td><td> <p>XX </p></td><td> <p>5.X% </p></td><td> <p>X.0% </p></td></tr> <tr> <td> <p>Cost XX debt (after tax) </p></td><td> <p>XX </p></td><td> <p>3.X% </p></td><td> <p>3.9% </p></td></tr> <tr> <td> <p>Cost XX equity </p></td><td> <p>8.2% </p></td><td> <p>X.X% </p></td><td> <p>10.X% </p></td></tr> <tr> <td> <p>XXXXXXXXXX XXXX </p></td><td> <p>0% </p></td><td> <p>30% </p></td><td> <p>XX% </p></td></tr> <tr> <td> <p>Percentage equity </p></td><td> <p>XXX% </p></td><td> <p>XX% </p></td><td> <p>XX% </p></td></tr> <tr> <td> <p>XXXXXXXX XXXXXXX </p></td><td> <p>8.X% </p></td><td> <p>X.8% </p></td><td> <p>8.X% </p></td></tr> <tr> <td> <p> </p></td><td> <p> </p></td><td> <p> </p></td><td> <p> </p></td></tr> </tbody></table> <p> </p> <p>XXX XXXXX XXX the WACC XXX be XXXXXXXX XXXX XXXXXXXXXXX the weights XX XXX required returns XXXXXXX XXXXX Oak XX XXXXXX XXXX 30% XXXX and 70% XXXXXX. Because debt payments are XXX deductible XXXXXXXXX it XXXX XXXXX XXX only X.3% to XXXXXXX debt XXXXXXX XX 5.0% with a XXXXXXXX tax rate of XX%. XXX White Oak XXX calculated cost of XXXXXXX estimate is XX follow: </p> <p><i>WACC (XXXXX XXX) = X.30 × X.X% + X.70 × X.X% = X.X%. </i> </p> <p>Similar XXXXX has XXXX used XX XXXXXXXX XXX XXXX of XXXXXXX XXX XXXXX </p> <p><i>XXXXX at X.X%: WACC (Moose River) = X.40 × X.X% + X.XX × XX.X% = X.X%. </i> </p> <p><b>Findings and Recommendations</b> </p> <p>Two different XXXXX XX investors are involved for XXX XXXXXXX of XXXXXX at XXXX XX the firm XXXX as XXXXXX XXXXXXXXX XXX debt investors. XX order XX XXXXX the XXXXXXXX XXXXXX XXX the assets XX each firm the weighted average XXXXXXXX XXXXXX of XXXXXX XXX XXXX investors. XXX standard XXXXXXXX XXX XXXX of capital XXXXXXXXXX is determined XXXXXXX XXX XXXXXX of estimating a XXXXXXXX XXXXXXX cost of capital (WACC) XX using XXX XXXXXXXX average of the prevailing costs of XXXX and XXXXXX. It XX important XX XXXXXX XXXX the XXXX and XXXXXX characteristics of XXX XXXXXX XXXXXXXXXXXX of how the XXXXXX XX the XXXXXX are divided; XXXX XX XXX XXXXX XXXXXXX XX XXX WACC. There XXX been maintained certain XXXXXXXXXXX while estimating XXX cost XX capital. XXXXX XXX risk profile XXXXXX XX XXXX and XXXXXXX XXXXXXXX XX XXXXX different XXXX XXX main bakery XXXXXXXX XX XXX XXXXX XXXXX therefore, XXXXX XXXXX XXX been excluded. XXXX XX Tasty Bread is XXXXXX XX XXXXXXXX XXX XXXX adjusted XXXXXXXXX XXXX XX X.0%. XXXXX making the investment XXXXXXXX XXX selection of comparable XXXXX XXX XXXX XXXXXXXXX, XXXXXXXXX in order XX XXXXXXX XXXX decision XXXX XX XXXXX Bread is XXX XXXXXXXX on the XXXXX the XXXX of capital isn't XXX cost XX funds. XXX XXXXXXXXXXX cost of capital should XX taken XXXX XXXXXXXXXXXXX XXXX XXX XXXX of funds when XXXXX Tasty XXXXX's XXXXXXX XXX investment. In XXXXXX XXXXX, the jams and jellies XXXXXXXXXX XXXXXXXX to be more XXXX the benchmark of XXXX and jellies XXX XXX the bakery XXXXXXXXX; this XXX shows XX XXXXXXXX where XXX money is XXXXX and not where the money is XXXXXX. </p> <p>Tasty Bread's XXX and jellies investment XX estimated XX XXX weighted XXXXXXXX XXXXXXXXX of Moose XXXXX X.X%, XXXXX Oak X.8% and XXXXXXXXX Mountain X.2%. The XXXXXXXXXXX of the XXXXXXXXX XXXXXXXXX XXX XXXXXXXXXX XXXX XXX appropriate hurdle XXXX for XXX XXXXXXXXXX project XXX 8.0% since XXXX XXXXXXXX to XX XXX XXXXXXXXXX XXXX XX capital XXX investments of similar XXXX. Because the X.0% XXXX XX XXXXXXX XXXXXXXX XXX XXXXXXXX return XX 7.X% </p> <p>XXXXX XXX X.X% cost XX capital exceeds that the XXXXXXXX return of 7.X% XXXXXXXXX it XXXXX not create economic value for jam XXX XXXXXXX XXXXXXXXXX under the current XXXXXXXX. It is viable for Tasty Bread to XXX a XXXXXXXXXX XX XXXXXXXXXX XXXXX in order to XXXXXX the estimation XXXXX XXXXXXXXXX with individual WACC estimates XXX X.X% XXXX of capital is XXXXXXXX XX XXX XXXXXXXXXXX estimate for XXXXX XXXXX XXXXX on XXX XXXX XX capital XXXXXXXXX of the comparable XXXXX XXXXXX than XXX own cost XX XXXXXXX (Michael,XXXX). </p> <p><b><i>XXXXXXXXXXX Considerations </i></b> </p> <p>The J.X XXXXXXX Company can XXXX XX XXXXXXXXXXX XX an XXXXXXXXXXX comparable company XXX estimating XXX cost of XXXXXXX at Tasty Bread. The XXXXXXXX outcome of weighted XXXXXXX XXXX of XXXXXXX XX these XXXXXXXXXX XXXXXXXXXXXXXX can compare XXXX the above calculated XXXXXXXX average cost XX capital XX XXXXX comparable firms XXX in XXXX XX XXXXXXX XXXXXXX a XXXXX XXXX associated then it XXXX be a XXXX alternative XXXXXXXXX XXX. </p> <p><b><i>Estimating XXXX of Equity: </i></b>XXX total XXXX XXXXX of equity XX XXXXXXX XX XXXXXXXXXX as$7.1 billion. Based on a XXXXX XXXXX of $107 as XXXX as XXXXXX XXXXXXXXXXX XX XXX million. X.7% XX CAPM is used in estimating XXXX XX XXXXXX XXXXX on XXXXXXXXX XXXX XX 0.X, a market risk premium XX X.X% and a XXXXXXXXXX long XXXX Treasury XXXX yield XX 3.1%. </p> <p><b><i>XXXXXXXXXX XXXX of Debt:</i></b> XXX total XXXX value XX XXXXXXX is XXXXXXXXXX $X.X XXXXXXX XXXX includes $X.X XXXXXXX XXXX XXXX debt XXX $X.X billion XX XXXXX XXXX debt. XXX current weighted XXXXXXX interest XXXX on long XXXX debt is X.7% while on short XXXX it XX $1.2%. XXXXXXX yield to XXXXXXXX XX long XXXX debt XX X.5%. </p> <p><b><i>XXXXXXXXXX XXXXXXX Structure Weights: </i></b>Based on debt-XX-capital ratio XX XX%, cost XX XXXXXX of 8.X%, cost of debt of X.X% XXX XXXX XX Smucker XX XXXXXXXXXX XX below: </p> <p><i>WACC (XXXXXXX) = 0.XX × X.5% × (X − 35%) + 0.85 × 8.X% = X.X>#/i### </i></p> <p><i>The XXXXXXXXXX WACC of Smucker shows XX XXXXX as compare to the rates XXXXXXX XXXXXXXXX for three comparable XXXXX such as Moose River, XXXXX XXX XXX Sugarloaf XXXXXXXX. </i></p> <p><i><b>XXXXXXXXXX</b> </i></p> <p><i>This all XXXXXXX XXX XXXXXX risk XXXXXXXXXX with firm's XXXXXXXXXX. XXXXXXXXX XXXX XX XXXXXXX an XXXXXXXXXX return XX neutralize this XXXXXXXXXX risk. XXXX of X.7% of these alternative considerations provides confidence to lower the XXXXXXXXX project cost XX capital XXXX XX 7.8% on how comparable Pane believed XXXXXXX XX XX XX the risk of XXX XXXXXXXX project. XXXXXXXXX, it is XXXXXXXXXXX to use XXX XXXX of above XXXXXXXXXX three XXXXXXXXXX XXXXX so that there XXX be XXXXXXXX minimum XXXX XX return of %7.8 XX which Tasty XXXXX XXXXXXXX XXXXX for XXX XXXX investors as well XX equity investors. XX contrast, XX the firm's return XX XXXX XXXX its XXXX, XXX XXXX is XXXXXXXX XXXXX, indicating that it's an XXXXXXXXXXX XXXXXXXXXX (XXXXXXX,2014). </i></p> <p><i> </i></p> <p><i>References </i></p> <p><i>XXXXXXX,S. (XXXX). XXX XXXX XX XXXXXXX- XXXXXXXXXX and XXXXXXXX. XXXXXX XXXXXXXXXX XXXXXXXX. </i></p> <p><i>XXXXXX,D., & Head,A. (2016).<i>Corporate Finance: XXXXXXXXXX and XXXXXXXX</i>. London, England: Pearson. </i></p> <p><i> </i></p> <p><i> </i></p> <p><i> </i></p> <p><i> </i></p> <p><i> </i></p> <p><i> </i></p> <p><i> </i></p> <p><i> </i></p> <p><i> </i></p> <p><i> </i></p> <p><i> </i></p> <p><i> </i></p> <p><i> </i></p> <p><i><XX></i></p><p></p>">
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