Answer the following conceptual questions related to the estimation of WACC components. a. Should the weights...

Answer the following conceptual questions related to the estimation of WACC components.

a. Should the weights used to calculate the WACC be based on book values, market values, or something else? Explain.

b. If the company’s bond are publicly trading, how would you compute the pre-tax cost of debt? Explain first assuming that there is low chance of default and then assuming there is a high chance of default and hence expected loss.

c. Another approach to estimating cost of equity is the dividend growth approach. You need to have information regarding 3 inputs if you want to use this model – current price, current dividends, and the dividend growth rate. What are three ways to estimate the expected dividend growth rate?

Expert Solution

Q1: Ans: To calculate WACC weights are taken based on only market values of firm's equity and debts.Only market value of firm's equity and debt are considered.WACC is a major technique where average cost of capital is measured based up on market value of debt and equity taken,it reflects upon the share price of company stock to show its value to stakeholders about their investment strategies.

Q2: Ans:Pre tax cost of debt = total interest payment divide by total amount of debt

When the bond is publicly traded the cost of debt for bond will be equal to yield to maturity of debts. And market value of bond is taken for consideration.probability of risk occurining is considered while calculating risk of default.

- If chances of default is high, the lender will charge high interest on loan to borrower. and vice versa. for loss occurrance it is adjusted according to market value.For low chance of default lender charge low interest on loan.

Q3:Dividend growth model is a valuation model where dividend grow either at stable way or at fluctuating way.

- Analyst can use sustainable growth rate by using reton on equity and dividend payout ratio.

- They can use median industry growth rate based on observation.

- they can use future growth rate based up on historical growth of dividend.

jeff jeffy answered 1 year ago

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