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Time Warner's: Capital Structure and Cost of Capital

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For this task, you are computing and report on the weighted average cost of capital (WACC) estimate for Time Warner.

To this end it will be useful to use the following table:
COMPANY NAME:____________________________ Balance sheet date:_______________
Market values date:_______________
(a) (b) (c) (d) (e) (f) = (d) x (e)
Short term liabilities
Long term liabilities
Shareholders' Equity
Total 1.0000

The book values in column (b) are values that appeared in the most recent balance sheet of Time Warner. You are to add together all of the items that appear under shareholders' equity into one number - the total.

The total of the book value is of course equal to the 'book' or 'balance sheet' value of the firm's assets.
In column (c) insert your estimates of the 'market values'.
- For short term liabilities: you are to assume that the market value is equal to the 'book value'.
- For long term liabilities - use the present value of the long term liabilities that you have estimated in SLP3. Please review your work on the former section of the Session Long Project.
- For equity - the market value of equity is the total number of shares outstanding times the market price per share as of the date that you are working on the SLP. Please state the date for which you obtained this market price in the line that spells "Market value date" above.
- Now add the three items in the Market Value column. The sum total of the three items in the market value column, column (c), is the market value of the enterprise.

In column (d) insert the proportion of each item. You do this by dividing each number in column (c) by the total of this column. Please write the proportions up to four digits after the decimal point. The sum of these proportions must add up to 1.0000.
In column (e) you insert the cost of each of the sources of financing:
- For short term liabilities please find out what is the present rate of interest that companies pay on short term loans. You may ask your banker or consult the following web site: http://www.thefinancials.com/free/EX_Interest_MajorST.html.
- You may assume that Time Warner is currently paying the non-financial CD rate (Third line in the table of the web site). The cost of short term liabilities is the after tax cost, that is: the interest rate times (1 - T), where T is the corporate tax rate that you may assume T = 0.34 (that is 34%.)
- For long term liabilities: either use the yield to maturity of your corporate bonds (if available) by taking an average of the different bonds that were issued by Time Warner and that are traded, or you may assume that you company pays on its long term liabilities an interest rate that is about 1% higher than the present yield to maturity of a 5-year US Government bond. You therefore find out the present yield to maturity on a 5-year US Government bond, for example here, http://www.bloomberg.com/markets/rates/index.html and add 1% to that yield. You then multiply the result by (1 - T) because interest on company's debt are deductible for tax purposes and the effective after tax cost of debt is the yield the company is to pay times (1 - T).
- For equity: Use the beta of Time Warner and the computation of the cost of equity from the previous report of the Session Long Project to insert the cost of equity (in %). Note: the cost of equity is not a deductible expense for tax purposes and therefore this number is not multiplied by (1 - T). It follows that the most expensive source of funds is shareholder's money.
Do not sum up the numbers in column (e).
In column (f) you simply insert the product of each number in column (d) by the corresponding number in column (e).
You now add up the first three numbers in column (f).
The sum of these numbers is Time Warner's weighted average cost of capital (WACC.)

Prepare a report describing the computations of the weighted average cost of capital of Time Warner. You'll be using the report for the final part of the Session Long Project.

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Solution Preview

The cost of capital can also be viewed as the minimum rate of return required keeping investors satisfied. Thus it is used to know the rate of return expected by the investors. Thus cost of capital is used to evaluate the project. It is also know as discount rate.

Thus it is used to know the rate of return expected by the investors.

Cost of capital (WACC)=
(Cost of Equity x Proportion of equity from capital)+ (Cost of debt x Proportion of debt from capital)+ (Cost of Preference share x Proportion of preference share from capital).

Equity includes retained earnings and the cost of R/E is taken at cost of equity. Cost of equity capital is the opportunity return from an investment with same risk as the company has. Cost of equity is usually defined with Capital asset pricing model (CAPM). The estimation of cost of debt is naturally more straightforward, since its cost is explicit. Cost of debt includes also the tax shield due to tax allowance on interest expenses. In case of preference shares, the dividend rate can be taken as the cost since it is the amount, which the company intends paying against preference shares. As is the case of debt the issue expenses or discount/premium on issue has also to be taken into account.

When investors are shopping for places in which to invest their funds, they have an opportunity cost. The firm, given its riskiness, must strive to earn the investor's opportunity cost. If the firm does not achieve the return investors ...

Solution Summary

This solution explains the steps required to compute the Time Warner's capital structure and cost of capital. An attached Excel file is provided which contains all of the calculations.