DOMINO’S PIZZA ENTERPRISES (AUSTRALIA):
WEIGHTED AVERAGE COST OF CAPITAL
1.What is the cost of capital and why is it important?
2. How should Coney estimate the cost of debt?
3. How should Coney estimate the cost of equity?
4. What is the WACC?
5. How is the WACC used in evaluating future projects?
Answers:
1) The cost of capital is the rate of return that a company is expected to earn
on its investments in order to satisfy its investors and maintain its financial
stability. It is important because it is used as a benchmark to evaluate the
profitability of investments and to make decisions about capital structure,
such as whether to finance new projects with debt or equity. The cost of
capital measures the cost that a business incurs to finance its operations. It
measures the cost of borrowing money from creditors, or raising it from
investors through equity financing, compared to the expected returns on
an investment. The cost of capital refers to the minimum return required
by investors to invest their money in a company.
It is important because it helps the company to determine the minimum
return they need to generate from their investments to cover their cost of
capital and provide adequate returns to their investors. From Exhibit 1, we
can see that Coney's cost of capital is 10.6%, which is the weighted average
cost of debt and equity.
2) Coney can estimate the cost of debt by calculating the yield to maturity on its
outstanding debt or by using the current market interest rate for similar debt
issued by comparable companies. Alternatively, the cost of debt can also be
estimated by adding a premium to the risk-free rate to account for Coney's credit
risk. Coney can estimate the cost of debt by calculating the yield to maturity on
their existing debt. The team would need the accurate corporate tax rate to
calculate the cost of debt .
3) Coney can estimate the cost of equity using the capital asset pricing model
(CAPM), which takes into account the risk-free rate, the market risk premium, and
the company's beta. Alternatively, Coney can use the dividend discount model
(DDM) if it pays dividends, which values the stock based on its expected future
dividends. From Exhibit 4, we can see that the risk-free rate(considering 30 years
Bond rate) is 1.79%, and the market risk premium is 6.25%. Assuming a beta of
1.005(taking average beta ) for Coney, the cost of equity can be estimated as
follows:
Cost of equity = Risk-free rate + Beta * Market risk premium
Cost of equity = 1.79% + 1.005* 6.25%
Cost of equity = 8.07%
4) The weighted average cost of capital (WACC) is the average cost of all the
capital a company has raised, including debt and equity, weighted by the
proportion of each type of capital in the company's capital structure. It
represents the minimum return that a company must earn on its investments to
satisfy both debt and equity investors. The weighted average cost of capital
(WACC) is the average cost of the company's debt and equity, weighted by their
respective proportions in the company's capital structure.
5) The WACC is used in evaluating future projects as a discount rate to calculate
the net present value (NPV) of the project. If the NPV is positive, the project is
expected to generate a return greater than the WACC and is therefore deemed to
be a viable investment. If the NPV is negative, the project is expected to generate
a return lower than the WACC and should be rejected. The WACC is used as a
discount rate in evaluating future projects to determine whether they will
generate returns that are higher than the company's cost of capital. If a project
generates returns higher than the WACC, it is considered profitable and should be
undertaken, whereas a project with returns lower than the WACC is not worth
pursuing. By using the WACC, companies can make informed investment
decisions and ensure that their investments generate adequate returns for their
investors.
