Question

1. What factors may influence a company's weighted average cost of capital? Why?
2. According to the authors of “Value Creation at Anheuser-Busch: A Real Option Example”, what are the real options available to the company specifically or to the company's industry in general?
3. Consider an industry of your choice (other than the pharmaceutical industry). Identify and discuss a real option that might exist for firms in that industry.

PLEASE ANSWER THE THREE QUESTIONS THANKS

Answer 1

1. What factors may influence a company's weighted average cost of capital? Why?

Weighted Average Cost of Capital (WACC)

The weighted average cost of capital (WACC) is the average after-tax cost of a company’s various capital sources. It includes common stock , preferred stock bonds, and other debt. WACC is calculated by multiplying the cost of each capital source by its weight. Then, the weighted products are added together to determine the WACC value.

Factors

1. The weighted average cost of capital (WACC) is the average after-tax cost of a company's various capital sources.

2. The interest rate paid by the firm equals the risk-free rate plus the default premium for the firm.

3. When the Fed hikes interest rates, the risk-free rate immediately increases, which raises the company's WACC.

4. Other external factors that can affect WACC include corporate tax rates, economic conditions, and market conditions.

Economic Conditions

When a bank provides a company with easy loans to alleviate stability, the company’s debts are reduced subsequently. However, the cost of equity rises with this. The economic conditions of a country can also tend to affect the same.

One can calculate the weighted average cost of capital of their business using WACC calculator available on various reputed websites on the internet. These online calculators are effective and can calculate your WACC accurately.

Capital Structure

The value of debt to equity ratio also has an impact on your business’s weighted average cost of capital. If the debt is more massive than the share capital, then cost will subsequently become more. Moreover, if the stock capital is larger than the debt, the paying cost of equity has to be paid.

The capital structure affects your business finances and is yet another factor which can alter your WACC.

Dividend Policy

Each company dealing which large capitals and financial needs have a dividend and a policy with it. The amount of total earning of a company is the amount payable to debenture holders in the form of dividends.

Each financial year, the managers of the company calculate these costs and forward the information to the owner so that the payments could be made.

New Funds Received

If your business requires funds to meet a business need, you might need to turn up to the financial institution to raise funds. This condition might also lead the financial institutions in a more substantial risk, they eventually will increase the interest which you will have to bear to keep your business operations intact.

Therefore, your business becomes bound to accept the rate of interest and pay what is asked for. This might also affect the business’s cost of capital.

Income Tax Rates

Every profitable business needs to pay taxes. These would vary from time to time both due to changes in legislature and due to changes in the particular tax bracket the company ends up in. Countries which adopt a flat-tax-rate policy have a much more predictable tax burden, and thus WACC is easier to calculate in a predictive manner.

Any change in tax rates can alter your company’s WACC. The higher the taxes, the lower is the cost of capital and the lower the tax, the higher is the cost of capital.

Other external factors that can affect WACC include corporate tax rates, economic conditions and market conditions. Taxes have the most obvious consequences. Higher corporate taxes increase WACC, while lower taxes reduce WACC.

Why is WACC important to a company?

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.

The importance and usefulness of the weighted average cost of capital as a financial tool for both investors and companies are well accepted among financial analysts. It’s important for companies to make their investment decision and evaluate projects with similar and dissimilar risks. The calculation of important metrics like net present values and economic value added requires the WACC. It is equally important for investors making valuations of companies.

2. According to the authors of “Value Creation at Anheuser-Busch: A Real Option Example”, what are the real options available to the company specifically or to the company's industry in general?

The concept of real options is based on the concept of financial options; thus, fundamental knowledge of financial options is crucial to understanding real options.

Real options are most valuable when uncertainty is high; management has significant flexibility to change the course of the project in a favorable direction and is willing to exercise the options.

The real options approach is an extension of financial options theory to options on real/non-financial assets. Options are contingent decisions that provide the opportunity to make a decision after uncertainty unfolds.

The most common types are: option to expand, option to abandon, option to wait, option to switch, and option to contract. Option to expand is the option to make an investment or undertake a project in the future to expand the business operations

3. Consider an industry of your choice (other than the pharmaceutical industry). Identify and discuss a real option that might exist for firms in that industry.

REAL OPTION ANALYSIS EXAMPLE

Because traditional valuation tools such as NPV ignore the value of flexibility, real options are important in strategic and financial analysis. Consider the example of oil company, which has the opportunity to acquire a five-year license on a block. When developed, the block is expected to yield 50 million barrels of oil. The current price of a barrel of oil from this field is, say, $10, and the present value of the development cost is $600 million. Thus the NPV of the opportunity is simply:

$500 million - $600 million = -$100 million.

Faced with this valuation, the company would obviously pass up the opportunity.

But what would option valuation make of the same case? Such a valuation would recognize the importance of uncertainty. There are two major sources of uncertainty affecting the value of the block: the quantity and the price of the oil. The company can make a reasonable estimate of the quantity of the oil by analyzing historical exploration data in geologically similar areas. Similarly, historical data on the variability of oil prices are readily available. Assume for the sake of argument that these two sources of uncertainty jointly result in a 30 percent standard deviation (σ) around the growth rate of the value of operating cash inflows. Holding the option also obliges the company to incur the annual fixed costs of keeping the reserve active—let us say, $15 million. This represents a dividend-like payout of 3 percent (that is, 15/500) of the value of the asset. We already know that the duration of the option, t, is five years and that the risk-free interest rate, r, is 5 percent, leading us to estimate option value at

ROV = (500e^-0.03*5)*{(0.58)} - (600e^-0.05*5)*{(0.32)} = $251 million - $151 million = +$100 million.

Where does this $200 million difference come from? Consider a simple financial option, available at $17 for an exercise price of $70 when the stock is trading at $83. A buyer who exercised the option immediately would have a payoff of $13 but would be $4 out of pocket, having paid $17 for the option. The $4 represents the value of the flexibility inherent in not having to decide whether to make the full investment immediately, a flexibility whose value an NPV analysis would recognize as zero. So too in this case: the $200 million is the equivalent of the $4.

Ultimately, then, the option valuation recognizes the value of learning. This is important because strategic decisions are rarely one-time events, particularly in investment-intensive industrial sectors. NPV, which relies on all-or-nothing, "go/no go" decisions and doesn’t properly recognize the value of learning more before a full commitment is made, is for that reason often inadequate. In fact, NPV’s inadequacy can be stated in the precise terms of the real-options model. Of the six variables in that model, NPV analysis recognizes only two: the present value of expected cash flows and the present value of fixed costs. Option valuation offers greater comprehensiveness, capturing NPV plus the value of flexibility—that is, the expected value of the change in NPV over the option’s life