Question

1. 1- Make an argument for using the WACC to evaluate leasing.  2- How is this consistent with other capital budgeting problems?  3- How does the “sequencing problem” come into play?

Answer 1

1.

A lease is a contractual agreement between two parties, an owner of an asset (lessor) and the user of the asset (lessee). The agreement specifies that the lessee has the right to use the asset, and in turn must make periodic payments to the lessor.

Valuation of financial leases:

A valuation technique that is convenient in the valuation of leases is the weighted-average-cost-of-capital method.

In the conventional application of the WACC method, we have an initial outflow of cash, which is financed by some combination of debt and equity. The unlevered cash flows generated by this initial investment is discounted at the WACC.

In the case of a lease, on the other hand, we have an initial inflow, which reduces the amount of borrowing necessary from other sources. This initial inflow commits us to regular payments over time, which may be considered as reductions in profits generated by other projects. In this sense, a lease is an anti-project. As such, it is to be evaluated exactly as any other project would be, but for the fact that the signs are reversed.

The final question is what the applicable WACC will be. That depends on the debt-equity ratio that is appropriate. Note that the cash flows in leasing are similar to those involved in borrowing. The annual lease payments have to be made irrespective of the size of the firm's cash flows from operations. Hence leasing effectively displaces an equivalent amount of borrowing. Consequently, the appropriate WACC simply involves the cost of debt financing. The WACC, therefore, is simply rB(1- t).Net present value (NPV) is the widely used method of evaluating projects to determine the profitability of the investment. WACC is used as discount rate or the hurdle rate for NPV calculations. All the free cash flows and terminal values are discounted using the WACC.

2.

The weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All sources of capital, including common stock, preferred stock, bonds, and any other long-term debt, are included in a WACC calculation. A firm’s WACC increases as the beta and rate of return on equity increase because an increase in WACC denotes a decrease in valuation and an increase in risk.

WACC is the average of the costs of these types of financing, each of which is weighted by its proportionate use in a given situation. By taking a weighted average in this way, we can determine how much interest a company owes for each dollar it finances.

Debt and equity are the two components that constitute a company’s capital funding. Lenders and equity holders will expect to receive certain returns on the funds or capital they have provided. Since the cost of capital is the return that equity owners (or shareholders) and debt holders will expect, WACC indicates the return that both kinds of stakeholders (equity owners and lenders) can expect to receive. Put another way, WACC is an investor’s opportunity cost of taking on the risk of investing money in a company.

3.

The selection of an appropriate order for finite number of different jobs to be done on a finite number of machines is called sequencing problem. In a sequencing problem we have to determine the optimal order (sequence) of performing the jobs in such a way so that the total time (cost) is minimized.

• First is to fund it with the retained earnings. In this case, it would be reasonably correct to assume that the new project is funded with same capital structure. ...
• Second possibility is raising fund in the same capital mix.
• The book value of common equity or debt is applied while the use of the market value of those would be more appropriate.
• The coupon interest rate replaces the market yield.
• The impact of the tax shield might be missing.