H. J. Heinz Estimating the Cost of Capital in Uncertain Times Case Study Solution
In order to explain the relationship between expected rate of return of stocks and systematic risk (risk which cannot be diversified), CAPM (Capital Asset Pricing Model) is used. A direct relationship between the expected return over the stocks and systematic risk is derived through CAPM. A relationship between the asset’s beta, risk free rate (which in this case is taken from the Treasury bill rate) and the equity risk premium (generated through deducting the risk free rate from market risk premium) is obtained through this model.
The main idea behind the calculations of CAPM says that investors demand two types of compensations; first is the time value of money because as time passes, the value of money starts to decline and the worth of it will not be the same in future, second is the risk of no any business being able to be exempted from risk, every type of business has its own type of risks which can be systematic (un-diversifiable, volatile and market risk) or can be un-systematic (diversifiable, adjustable risk).
Risk free rate is the first part of CAPM which represents the compensation of time value of money to the investors, which is the cost of equity for the company because investors demand the compensations about the value of their money which is declining day by day. Risk-free rate is taken from the yield of government bonds like the U.S. Treasuries, because government bonds are considered to be risk free and they do not contain any type of risk (systematic or unsystematic) because government has low or in fact no any chances of bankruptcy.
The second part of the CAPM (equity risk premium and beta) represents the risk attached with businesses. Investors demand compensation for taking these additional risks which are associated with a business. That type of a risks, company adjusts by calculating the beta, which entirely relates to the company. Beta represents the risk associated with a business and it is same as market; beta greater than 1 shows the risk associated with a company is more than the market (more risky company than other companies in market or industry) and vice versa. Then we multiply beta with equity risk premium to calculate the overall risk associated with the company. Equity risk premium comprises on the deduction of risk-free rate from market-risk premium. (Investopedia, n.d.)
WACC as a Representation about overall Financing Cost
In order to calculate the cost of capital for a company, WACC (Weighted average cost of capital) formula is used. It comprises the equity cost derived from the multiplication of the weight of equity with expected return, which is derived through CAPM approach plus the multiplication of weight of debt with the expected return on semiannual bond maturing in 2032 plus the multiplication of weight of short term debt with the expected cost of short term debt. All of these multiplications represents the total cost of the equity.
WACC is the combined cost of all the capital sources like common stock, long term bonds, preferred stock and short term borrowings. A direct relationship exists between beta of a company and WACC, which means that an increase in beta causes an increase in the cost of equity, which ultimately translates into an increase in the WACC of a company. If WACC will increase, it will decrease the valuation of the company because WACC has a direct relation with risk; if WACC will increase it will automatically increase the risk of a company. (Investopedia, n.d.)………..
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