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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 XXXXX to XXX a XXXXXXXXXX of comparable XXXXX in order XX reduce XXX estimation error XXXXXXXXXX with individual XXXX estimates XXX 7.X% XXXX XX XXXXXXX XX regarded XX XXX XXXXXXXXXXX estimate for XXXXX XXXXX based XX the XXXX XX capital estimates XX the comparable firms rather than XXX own XXXX of XXXXXXX. </p> <p> </p> <p><b>Analyzing & Estimating XXX XXXX of XXXXXXX at XXXXX XXXXX</b> </p> <p>XX estimate XXX XXXX of capital XX XXXXX XXXXX there XXX XXXX made a XXXX analysis XX the Ben Torrada, a XXXXXX XX XXXXXXXXXXX team, XXXXXXXXX XXX return XXXX for 3 comparable XXXXXX XXXXXX XXXX in the jam and jelly XXXXXXXX such XX Moose XXXXX, White XXX XXX XXXXXXXXX Mountain XXX it XXX accessed XXXX XXX XXXX XXXXXXXXXX XXXX the XXXXXXX of XXXXX firms was XXXXXXX to XXXX he expected for XXX returns XX the proposal. </p> <p><b><i>Estimate the Cost XX Debt XXX XXXXXX</i></b> </p> <p>XXXXXXX estimated the required XXXXXX XXX XXXXXX XXX XXXX in XXXX firm to XXXXXXXX XXX required returns XXX X comparable firms. The following XXXXXXXXXX are meant to XXX the XXXXXXX in XXXXXXXXXXXXX estimating the XXXX of debt. </p> <p><i>Principle 1: </i>XXXX XXXX-XX-XXXX XXXXXXXX consider XXX prevailing XXXX premium XX debt of XXXXXXXXXX XXXX. </p> <p><i>Principle 2: </i>XXXX cost-of-debt measures XXX XXXX XXXXXXXXX with matching XXX XXXXXXXXXXXXXXX XX the investments being XXXXXXXXX XXXX XXX characteristics XX the business’s XXXXXXXXXX XXXX securities. </p> <p><i>Principle X: </i>XXXX cost-of-debt measures XXXXX XX the XXXXXXXXXXX XXXX XXX XXXX holders XXXXX. </p> <p>XXXXXX XX XXXXX XXX has XXXX financed XXXXXXX XXXX and XXXXXX, the XXXXXXX those XXXXXXX generated XXXX XXXXXXX XXXXX equity XX XXXX XX debt XXXXXXX. XXXXXXXXX to XXXXXXXXX XXXXX 1 the return XXXXXXXX XX the XXXXXX XXXXXXX (9.8%) XX substantially XXXXXX XXXX the XXXXXX required XX XXX XXXX XXXXXXX (5.X%) since XXX risk XXX the XXXXXX XXXXXXX XX XXXXXX as compare XX XXX XXXX XXX XXX XXXX XXXXXXX. XXXXXXX, debt XXXXXXX XXXXXXXXXX the XXXXX claim on XXX returns that's why XXXXX risk XXX XXXXX XXXX XXXXXX holders. XXX weighted XXXXXXX required return of debt XXX equity XXXXXXX equal to XXX required return on XXX assets XXXXXX since debt XXXXXXX XXX XXXXXX XXXXXXX XXXXXXX to XXXXXX the XXXXXXX XXXXXX returns. In XXXXXX XXXXX, the XXXX of XXXXXXX XXX XXX firm assets is equal to XXX WACC for XXX various XXXXX of investors. </p> <p>XXX assets XX XXXXXXXXX Mountain are XXXXXXXX XXXXXXXX through equity XXXXXX since it has XX XXXX. Consequently, the XXXX of equity (8.X%) XXXXXXXX an XXXXXXXX XX the XXXX of capital, since XXX equity XX the only source of capital. XX XXXXXXXXXXXXXX, XXX XXXXXXXX XXXXXX or XXXX XX capital XXX XXXXXXXXX Mountain XXXXXXXXXXX XX XXXXXXXX XXXXX Torrada’s XXXXXXXX XX XXXXXXXXX Mountain’s cost of XXXXXX, X.X% (XXXXXXX,2014). </p> <p><b><i>XXXXXXXXXXX the XXXXXXX XXXXXXXXX XXXXXXX XX XXXXX XXXXX</i></b> </p> <p>XX XXXXXXXXX XXXXXXX to debt XXX equity, it is XXXXXXXXX XX XXXXXX that they should reflect XXX values XXXXXXXXX find relevant. It is XXXXXXXXXX XX use XXX optimal XXXXXXX XXXXXXXXX weights in estimating the cost of capital XXX it XX inappropriate to reject XXX XXXXXXX XX it has an inappropriate capital XXXXXXXXX. XX order XX XXXXXX a WACC for the XXXXXX in XXX XXXX he used a XXXXXXXX average of XXXXXXXXX. XXX XXXXX X shows XXX XXXXXXXXXXXX XX XXXX XXXXXXXXXX. </p> <p><b>(XXXXX X) XXXX estimation</b> </p> <table> <tbody><tr> <td> <p> </p></td><td> <p>Sugarloaf Mountain </p></td><td> <p>XXXXX Oak </p></td><td> <p>Moose XXXXX </p></td></tr> <tr> <td> <p>Cost XX debt (XXXXXX) </p></td><td> <p>XX </p></td><td> <p>5.0% </p></td><td> <p>6.X% </p></td></tr> <tr> <td> <p>XXXX XX XXXX (after XXX) </p></td><td> <p>NA </p></td><td> <p>3.X% </p></td><td> <p>3.9% </p></td></tr> <tr> <td> <p>XXXX of XXXXXX </p></td><td> <p>X.2% </p></td><td> <p>9.8% </p></td><td> <p>XX.X% </p></td></tr> <tr> <td> <p>Percentage debt </p></td><td> <p>X% </p></td><td> <p>30% </p></td><td> <p>XX% </p></td></tr> <tr> <td> <p>Percentage XXXXXX </p></td><td> <p>XXX% </p></td><td> <p>XX% </p></td><td> <p>60% </p></td></tr> <tr> <td> <p>Weighted average </p></td><td> <p>8.2% </p></td><td> <p>7.X% </p></td><td> <p>X.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>For White Oak the XXXX can XX computed just XXXXXXXXXXX XXX XXXXXXX by XXX required returns XXXXXXX White Oak XX XXXXXX XXXX 30% XXXX XXX 70% XXXXXX. XXXXXXX debt payments XXX XXX XXXXXXXXXX XXXXXXXXX it cost XXXXX Oak only 3.3% to deliver debt returns of X.X% XXXX a marginal tax rate of 34%. For XXXXX XXX the XXXXXXXXXX cost of XXXXXXX estimate XX XX XXXXXX: </p> <p><i>WACC (White XXX) = 0.XX × 3.X% + 0.XX × X.X% = X.X%. </i> </p> <p>Similar logic XXX XXXX XXXX XX estimate XXX XXXX XX XXXXXXX XXX XXXXX </p> <p><i>River at X.X%: WACC (Moose XXXXX) = 0.40 × X.X% + X.60 × XX.X% = X.0%. </i> </p> <p><b>Findings XXX Recommendations</b> </p> <p>Two different XXXXX XX investors are XXXXXXXX XXX XXX funding XX assets at XXXX XX XXX XXXX such as equity investors and debt XXXXXXXXX. XX order XX infer XXX required XXXXXX XXX XXX assets of XXXX firm the XXXXXXXX average XXXXXXXX XXXXXX of equity XXX XXXX XXXXXXXXX. XXX standard XXXXXXXX for cost of XXXXXXX estimation XX determined XXXXXXX XXX method of estimating a weighted average XXXX of XXXXXXX (WACC) by using XXX weighted XXXXXXX XX the prevailing XXXXX of debt XXX equity. XX XX important XX remain same XXX XXXX XXX XXXXXX characteristics of the assets XXXXXXXXXXXX of how the XXXXXX XX the assets XXX XXXXXXX; XXXX is the basic XXXXXXX XX XXX XXXX. There has XXXX maintained certain discretions while XXXXXXXXXX XXX XXXX of capital. Since the XXXX profile linked to jams XXX XXXXXXX business is XXXXX different from XXX XXXX bakery XXXXXXXX XX the XXXXX Bread therefore, Tasty XXXXX XXX been XXXXXXXX. XXXX of Tasty XXXXX is deemed XX suitable XXX risk adjusted benchmark XXXX XX X.X%. XXXXX XXXXXX XXX XXXXXXXXXX decision XXX selection of XXXXXXXXXX XXXXX has some XXXXXXXXX, therefore in order to XXXXXXX this XXXXXXXX WACC of Tasty Bread XX XXX included on the basis the cost of capital isn't the XXXX of funds. The opportunity cost XX XXXXXXX should XX XXXXX into consideration XXXX the cost XX funds XXXX XXXXX Tasty XXXXX's capital for XXXXXXXXXX. In simple words, XXX jams XXX jellies XXXXXXXXXX required XX XX XXXX than the XXXXXXXXX of jams XXX XXXXXXX and not the XXXXXX benchmark; this all XXXXX XX consider XXXXX XXX money is XXXXX XXX XXX XXXXX the money is coming. </p> <p>Tasty XXXXX's jam XXX jellies investment XX estimated by the XXXXXXXX averages estimates XX Moose River X.X%, XXXXX Oak 7.8% XXX Sugarloaf XXXXXXXX 8.2%. XXX XXXXXXXXXXX of the estimates increased his XXXXXXXXXX XXXX the XXXXXXXXXXX XXXXXX XXXX XXX the investment XXXXXXX was 8.0% XXXXX XXXX appeared to XX XXX prevailing cost XX XXXXXXX for investments of XXXXXXX risk. XXXXXXX the 8.0% cost XX XXXXXXX exceeded XXX XXXXXXXX return of 7.5% </p> <p>Since the X.0% XXXX of XXXXXXX XXXXXXX that XXX XXXXXXXX XXXXXX XX 7.X% therefore it XXXXX not create XXXXXXXX XXXXX for jam and XXXXXXX XXXXXXXXXX XXXXX XXX XXXXXXX proposal. XX is viable XXX XXXXX Bread XX XXX a XXXXXXXXXX of XXXXXXXXXX firms in order to XXXXXX XXX XXXXXXXXXX error XXXXXXXXXX XXXX individual WACC XXXXXXXXX and X.X% cost of XXXXXXX is XXXXXXXX as the appropriate estimate for Tasty Bread based on XXX cost XX XXXXXXX XXXXXXXXX of the XXXXXXXXXX XXXXX rather XXXX XXX own cost XX capital (Michael,2014). </p> <p><b><i>Alternative XXXXXXXXXXXXXX </i></b> </p> <p>The X.X Smucker XXXXXXX can also be recommended as an alternative comparable XXXXXXX for estimating XXX XXXX of XXXXXXX at XXXXX Bread. XXX resulted outcome XX XXXXXXXX average cost of capital of these XXXXXXXXXX XXXXXXXXXXXXXX XXX compare XXXX XXX above calculated XXXXXXXX XXXXXXX cost XX capital XX XXXXX XXXXXXXXXX XXXXX and in case XX Smucker signals a XXXXX risk XXXXXXXXXX XXXX it will be a XXXX XXXXXXXXXXX XXXXXXXXX not. </p> <p><b><i>XXXXXXXXXX XXXX XX XXXXXX: </i></b>The XXXXX XXXX XXXXX of XXXXXX XX Smucker is calculated as$X.1 XXXXXXX. Based XX a share XXXXX XX $XXX XX well as shares outstanding of 120 XXXXXXX. 8.X% of CAPM is XXXX in estimating XXXX XX equity XXXXX XX XXXXXXXXX XXXX XX X.X, a market XXXX premium of 6.X% XXX a XXXXXXXXXX XXXX term Treasury XXXX XXXXX of 3.1%. </p> <p><b><i>XXXXXXXXXX Cost XX XXXX:</i></b> XXX total book value of XXXXXXX is calculated $2.X XXXXXXX XXXX XXXXXXXX $X.9 XXXXXXX long XXXX debt XXX $0.X billion XX XXXXX term debt. The XXXXXXX weighted average XXXXXXXX rate on long XXXX XXXX is 4.X% XXXXX XX XXXXX XXXX it XX $1.X%. XXXXXXX XXXXX to maturity of XXXX term XXXX XX X.5%. </p> <p><b><i>Estimating Capital Structure Weights: </i></b>XXXXX on debt-XX-capital ratio of XX%, XXXX XX XXXXXX XX X.5%, XXXX of debt XX X.5% XXX WACC XX XXXXXXX is calculated XX XXXXX: </p> <p><i>XXXX (Smucker) = 0.XX × 4.5% × (1 − XX%) + X.XX × 8.X% = 7.X&XX;#/i### </i></p> <p><i>The XXXXXXXXXX WACC XX Smucker XXXXX XX XXXXX as compare XX XXX XXXXX already XXXXXXXXX for three comparable firms such XX XXXXX River, XXXXX Oak XXX XXXXXXXXX Mountain. </i></p> <p><i><b>XXXXXXXXXX</b> </i></p> <p><i>This XXX XXXXXXX the XXXXXX risk XXXXXXXXXX with firm's XXXXXXXXXX. XXXXXXXXX XXXX XX require an additional XXXXXX to XXXXXXXXXX this XXXXXXXXXX risk. XXXX of 7.X% of XXXXX alternative XXXXXXXXXXXXXX XXXXXXXX XXXXXXXXXX to lower the XXXXXXXXX project cost of XXXXXXX XXXX is 7.8% on how XXXXXXXXXX Pane XXXXXXXX Smucker to XX to the risk XX the proposed XXXXXXX. Therefore, it XX XXXXXXXXXXX to use XXX WACC of above calculated XXXXX comparable XXXXX so XXXX XXXXX XXX XX XXXXXXXX minimum XXXX XX XXXXXX XX %X.X at XXXXX Tasty XXXXX XXXXXXXX XXXXX for XXX XXXX investors XX well XX XXXXXX investors. XX XXXXXXXX, XX the firm's return XX XXXX than its WACC, the XXXX is XXXXXXXX XXXXX, indicating XXXX it's an unfavorable investment (XXXXXXX,2014). </i></p> <p><i> </i></p> <p><i>References </i></p> <p><i>Michael,S. (XXXX). XXX XXXX XX XXXXXXX- Principles XXX Practice. XXXXXX Publishing XXXXXXXX. </i></p> <p><i>Watson,D., & Head,X. (XXXX).<i>Corporate XXXXXXX: XXXXXXXXXX XXX Practice</i>. London, XXXXXXX: XXXXXXX. </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><br></i></p><p></p>">
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