choose Variables for a sensitivity analysis, Finance Basics

Assignment Help:

You are asked to select three variables for a sensitivity analysis of weighted average cost of capital, what would you choose and why?

  • Weighted average cost of capital is the average of the required return required by each providers of finance. Funds can be provided by common stock holders or debt holders. Common stock holders charge equity rate of return and debt holders charge a debt rate of return.
  • Equity rate of return is calculated using following formula:

Expected return = risk free rate + beta (Market rate minus risk free rate)

Debt holders simplycharge a percentage say 10% per annum.

Weighted average cost of capital is then calculated based on the amount of each equity and debt used in the total capital

  • Now based on the above formulas, the three variables for sensitivity analysis of weighted average cost of capital could be:

(a)    Risk free rate = The risk free rate is the rate paid by US treasury on sovereign bonds. Now this rate may change and change the equity rate of return. Specially during times of crisis, the risk free rate fluctuates as the governments try to reduce the impact of recession on the economy. High risk free rate will lead to high equity rate of return and high weighted average cost of capital and vice versa.

(b)   Market rate - This is generally based on the returns generated by the broad market index such as SNP 500 etc. These may change based on how the index is performing. During boom periods, they generate better returns as compared to bad periods. High market rate will lead to high equity rate of return and high weighted average cost of capital and vice versa.

(c)    General interest cost in the country - This is based on the general interest rate declared by central bank of various countries such as Federal Reserve of USA plus appropriate premium. Central banks lend money to various commercial banks at the general rate of interest and then these commercial banks add suitable market risk premium depending upon on the risk involved in the project. Hence, general rate of interest will lead to higher rate of debt and higher weighted average cost of capital and vice versa.


Related Discussions:- choose Variables for a sensitivity analysis

Comparison between debt finance and ordinary share capital, Comparison betw...

Comparison between Debt Finance and Ordinary Share Capital Differences between Debt Finance and Ordinary Share Capital as Equity Finance as   Ordina

Hedging at Porsche, 1. Should Porsche hedge its foreign exchange risks? 2...

1. Should Porsche hedge its foreign exchange risks? 2. How does Porsche hedge its foreign exchange risk? 3. What is the best hedging strategy? 4. How did Porsche build its Vo

Conditions under which Loans Are Ideal, Conditions under which Loans Are Id...

Conditions under which Loans Are Ideal a) Whenever the company's gearing level is low as the level of outstanding loans is low. b) The company's future cash flows as inflows

Objectives of business entity, Objectives of Business Entity The Main ...

Objectives of Business Entity The Main objectives of a business entity are clarified in detail below. Any business firm would have specific objectives that it aims at achievin

Find the costs of financing, Find the costs of financing for two schedules ...

Find the costs of financing for two schedules of monthly payments on a 25-year mortgage. The cash value of the house today is $500,000. You are paying monthly at a fixed rate of 6%

Describe briefly the term measures of variability, Question: (a) (i)...

Question: (a) (i) Define the term multicollinearity. (ii) Explain why it is important to guard against multicollinearity. (b) (i) Sometimes we encounter missing value

Constant amount per share or fixed d.p.s., Constant amount per share or fix...

Constant amount per share or fixed D.P.S. 1. The DPS is fixed in total amount of irrespective of the earnings level. These generate certainty and are consequently preferred vi

Ros - return on sales-profit margin , ROS - Return on Sales (Profit Margin)...

ROS - Return on Sales (Profit Margin) The Average of the industry ROS was 5.18% for 2004, 4.41% for 2005, and 7.20% for 2006. The chart showed that ROS has been declined f

Present value of an annuity, Determine the Present Value of An Annuity and ...

Determine the Present Value of An Annuity and give explanation of this topic?????

Venture capital, Venture Capital Venture capital is a form of investme...

Venture Capital Venture capital is a form of investment in new small risky enterprises utilized to get them started via specialists called venture capitalists. Venture capital

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd