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12 Cards in this Set
- Front
- Back
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Why is WACC important? |
It establishes the minimum return required to satisfy both lenders and shareholder |
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WACC formula |
WACC = Kd x (1 - Tc) X (D/D+E) + Ke X (E/D+E) Conceptually the marginal tax rate should be used not the average effective tax rate |
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Difficulties in achieving desired capital structure |
Share price fluctuations can render the debt/equity mix sub-optimal as market values are used. It can be difficult to pay down in these instances For public companies it is easy to determine market value of equity and debt however for unquoted it must be estimated |
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Floating rate Debt Value |
Should be the nominal value as it resets frequently |
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Why are market values used in WACC calculations |
It is in effect the sacrifice the investor is making by holding the instrument. |
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Adjusting WACC for strategic cash |
Can be done only if the cash is not used as part of the operating assets of the business (e.g airlines) Situations where it can be used in when itcan't be offset because of accounting policies such as pooling arrangements. It will cause distortions to WACC calcualtions as cash generates less of a return than debt.
It can then be included in WACC calculations as a negative value.
Kd x (D/ D-C + E) etc. |
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Difficulties in using WACC for overseas investments |
Can currency risk be eliminated entirely? What is the relevant market index/ Difficult to ascertain the systematic risk Policitcal and Country risk factirs |
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Solutions to international projects |
Agree rights and obligations with host government at the outset Operate project in such a way to lower risk such as retaining control of key patents Prepare contingency plans Take out insurance |
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Discounting at foreign vs. domestic rate |
In theory if interest rate parity holds true then the NPV should be the same if you discount at domestic after converting foreign flows or discount at foreign and convert final figure. This is realistic in practice for a few years because the forward rate can be locked in but after a few years it will no longer hold true. |
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How to determine the discount rate for foreign projects? |
By diversifying internationally the variance of thr investors portfolio is generally reducedand therefore the risk premium can be reduced Overall the focus should be on systematic risk, not the total risk when assessing foreign projects |
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Cost of debt for multinational corporations |
Cost of debt for an Mnc is higher in some countries because: -Risk-free rate is higher (due to monetary policy or anticipated inflation) -Risk premium is higher. General economic conditions influence this. E.g vulnerability to recession Although diversification of projects internationally should lower risk, it is offset by agency costs of debt, fx risks and asymmetric info costs. T can reduce this by: -Accessing deep and efficient markets -Reducing FX risks Facilitating information flow and maintaining close dialogue with credit rating agencies Managing political/economic risk by continuing assessment of the domiciles of potential debt holders and countries of issue Overall retain as much flexibility as possible |
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When should WACC be used as discount rate |
WACC should be used as the discount rate when: • Individual projects will be financed in such a way as not to change the capital structure of the firm. • Individual projects have the same degree of systematic risk as that of the firm’s existing cash flows. |
