WACC Case Study

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The weighted average cost of capital, commonly referred to as WACC, is an important and widely accepted tool for companies to use. WACC allows the company to value future projects and the company as a whole by proportionately weighing each category of capital; because of this a firm’s WACC is dependent on the capital structure of the firm. Investors also use this tool to confirm whether or not companies are worth the investment risk. The higher the WACC, the higher the investment risk of a company. This is due to an increase on the rate of return on equity and beta. Companies use WACC to evaluate new projects. By discounting potential investments by the WACC, we can determine if the potential project or investment will have a high enough return to satisfy the various investors.
The asset beta method is another widely used tool for valuing the future projects …show more content…
First, we found the equity beta by locating the market returns for both IBM and the S&P 500 from 2005 to 2014. We chose to go all the way back to 2005 to reflect both good and bad times in the market in our calculations. Equity beta is calculated by taking the covariance of the change in percentages for IBM and the S&P and dividing it by the variance in the percentage change in the S&P. Equity beta, also known as “levered beta” is the beta of the firm with financial leverage, and is used to determine the asset beta of the firm. The asset beta, also known as “unlevered beta” is calculated by taking the equity beta, calculated above, and multiplying it by the ratio of total equity to total value of the firm. By doing so it effectively takes out the financial leverage, unlevering beta. Finally, asset beta is put into the CAPM equation with the same December 2014, 10 year Treasury Bill rate and market risk premium as used in the WACC method giving IBM a discount rate of 4.09% per the asset beta

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