Therequired return is the minimum earnings on an investment that wouldinduce investors to invest their funds into it. In corporate finance,the required return is equal to the WACC. The first step in the WACCprocess is identifying the market value of the firm’s equity. Here,one multiplies the number of common shares by the share price. Then,one calculates the market value of the debt. Here, number of bonds ordebt multiplied by the price per bond. We then sum the market valueof equity and the bonds to get the total value of the firm(Groppelli,& Nikbakht, 2012). Tofind the weight of equity we take the market value of equity dividedby the total value of the firm. To find the weight of the debt or thebond, we take the market value of the debt divided by the total valueof the firm as shown in the formulas below.
Inthe second step, one calculates the cost of equity. Here, we can usethe Capital Assets Pricing Model where we take the beta times therisk premium plus the risk-free rate (Schlueter,Christofides, & Mitra, n.d.). Therisk premium can be calculated by taking the market risk less therisk-free rate. The formula below shows the calculation of the costof equity.
Thethird step is the calculation of the cost of debt by using the Yieldto Maturity (YTM) formula as shown below.
Thefinal step is the calculation of the WACC where we incorporate theweights and the costs in the formula below.
Thereare three types of risk factors that must be allowed for whencalculating the required return. They include business risk,non-business risk, and financial risk. Business risks are those takenby a business to maximize its shareholder value while non-businessrisks are those risks that are not under the control of the firm likeeconomic and political risks (Fields,2011). Financialrisks, on the other hand, are those risks that involve financiallosses to the firm. They include market risk, credit risk, liquidityrisk, and operational risk. All these risks must be incorporated whencalculating the required return.
Whenwe incorporate the government and policy changes in the past twelvemonths, a gamma or a proportion of imputation credits is to beintroduced in the calculation of the cost of debt. Here, we take oneminus the tax rate divided by one minus the gamma multiplied by oneminus the tax rate. The resultant figure should be multiplied to thecost of debt. The cost of debt after this change was higher than whenthe change was not incorporated. This would increase the riskassociated with the investment portfolio leading to a higher return(Skinns,Scott, & Cox, 2011). Theoverall risk of each element would be low since we are calculatingthe weighted cost of each risk element or factor.
Severalrisk elements could affect a U.S. auto manufacturer when building an$ 800 million plant in China. These risks include adjustments forprojects with no cash inflows, new products in the market that couldthreaten their market share, foreign exchange risk, cultural risk,and political risk (Schlueter,Christofides, & Mitra, n.d.). Assuminga WACC of 12%, adjustments to projects with no cash inflows would beroughly 1%, new products entering the market would be 9%, foreignexchange risk would be 2%, cultural risk would be approximately 3%,and a political risk of 3% giving a total required return on 29%.
Thereason why I chose a 1% adjustment to projects with no cash flow isthat start-up businesses are not likely to boom immediately afterstarting operations (Schlueter,Christofides, & Mitra, n.d.).I chose a 9% risk for new products entering the market since the U.S.auto manufacturer would likely face competition from products thatare of high quality and that are being sold at a lower price. I chosea 2% foreign exchange risk, a 3% cultural risk and a 3% politicalrisk since when the U.S. auto manufacturer enters China it would beforced to convert its currency, which could be risky it would alsoface different cultures, and political instability in China wouldthreaten its existence.
Groppelli,A. & Nikbakht, E. (2012). Finance.Hauppauge, N.Y.: Barron`s. retrieved on 19 August 2016.
Schlueter,O., Christofides, N., & Mitra, G. Amethodology for company valuation.Retrieved on 19 August 2016.
Fields,E. (2011). Theessentials of finance and accounting for nonfinancial managers.New York: American Management Association. Retrieved on 19 August2016.
Skinns,L., Scott, M., & Cox, T. (2011). Risk.Cambridge, UK: Cambridge University Press. Retrieved on 19 August2016.
Bierman,J. & Smidt, S. (2014). AdvancedCapital Budgeting.Hoboken: Taylor and Francis. Retrieved on 19 August 2016.
Bossu,S. & Henrotte, P. (2012). Anintroduction to equity derivatives.Chichester, West Sussex, U.K.: Wiley. Retrieved on 19 August 2016.