Cost of Equity:
The CAPM says that the expected return on an investment equals to the rate on a risk free security plus the risk premium. If the expected return does not meet or beat the required return, then the investment should not be carried on and the security line plots the results of the CAPM for all different betas. The cost of equity using the CAPM model is 11.73%.
The cost of equity using the proxy for CAPM and adding 4% in the cost of debt is 14.45%.
The CAPM has several advantages over the other method of calculating the required rate of return and it is widely used by most companies to determine their cost of equity.
CAPM considers only systematic risk which reflects the reality in which most investors have diversified portfolios from which unsystematic risk has been essentially eliminated and WRL and Tyson both companies are diversified.
CAPM method also generates a theoretically-derived relationship between the return that is required and the systematic risk, which has been subject to frequent empirical research and testing.
It is a better method to calculate the cost of equity than the other method as it takes account of the level of systematic risk relative to the stock market as a whole and it is superior to the WACC in providing discounts rates for use in investment appraisal.
Valuation of WLR Foods:
The valuation of the WRL through the discounted cash flows method is $470 million and the Market value of equity is $400 million through which the share value has been derived and the value of share is $36.
In the calculation of the value of the company, the sales have increased in 1994 by 18.4%, 10% in 1995, 1996, 1997, 1998 and the growth of sales for the year 1999 is 6.2%. These assumptions have been taken because of the growth of the industry which is good for unforeseeable future and the past trends of the company. The growth rate taken for the terminal value is 4%, which is calculated after evaluating the past and future.
The marginal tax rate for the company is 40% and the market risk premium is 5.50%. The cost of debt is taken through the B rating of the corporate bonds, which is 10.45% and the risk free rate to calculate the cost of equity is taken as the rate of 30 year U.S Government Issues, which is usually the risk free rate.
The capital expenditures and the depreciation expenses are taken as given in the income statement of the company. The market value of the equity is calculated by subtracting the market value of debt from the enterprise value and the share price is calculated by dividing 11 million shares by the market value of equity.
The market value of debt is taken as $70 million as Tyson Foods made an assumption that the debt is valued at $70 million, which shows that the market price of the debt is approximately around this value.
Competitors Beta Effect on WACC and Valuation:
Using competitors’ beta by gearing and ungearing has the effect to change the WACC and the value of the company. However, in this case the re-gearing the beta of competitors has not affected the value and WACC as the beta of Tyson Foods is 1 and the calculated Beta is 0.98.
The cost of equity has only decreased from 11.73% to 11.6% due to which the WACC has changed from 9.53% to 9.46%.
The value of the company has increased from $470 million to $472 million, which is minimal and has not affected the price of the company much, which also means that the share price and market value of debt is also almost similar.
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