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

Cost of redeemable debentures and preference shares, Cost of Redeemable Deb...

Cost of Redeemable Debentures and Preference Shares Redeemable fixed return securities have an exact maturity period.  The cost of those securities is called redemption yield

Functions of central depository system or cds, Functions of Central Deposit...

Functions of Central Depository System or CDS 1. Immobilization of securities that is removal of physical movement of securities. 2. Dematerialization that is removal of ph

Basic eoq model, Basic EOQ Model The basic inventory decision model is...

Basic EOQ Model The basic inventory decision model is Economic Order Quantity or called EOQ model. This model is specified via the following equation as: Whereas:Q is

State about the odd-lot dealer, State about the Odd-lot Dealer He/she...

State about the Odd-lot Dealer He/she specializes in buying and selling in amounts which are less than present trading units. They buy and sell odd lots, make them up into ma

What are the types of money and bank regulations, What are the types of Mon...

What are the types of Money and Bank Regulations? Types of Money : a. Commodity money b. A commodity-backed money c. Fiat money Bank Regulations: a. Deposit i

Lock-box system, Lock-Box System In a lock-box system, the customer se...

Lock-Box System In a lock-box system, the customer sent the payments to a post office box. The post office box is emptied with the firm's bank at minimum once or twice all bus

Information signaling effect theory, Information Signaling Effect Theory ...

Information Signaling Effect Theory Advanced via Stephen Ross in year 1977, He argued such in an inefficient market; management can utilize dividend policy to signal significa

Throughput accounting, state a case where throughput according system is re...

state a case where throughput according system is required

Profitability in relation to investment, Profitability in relation to inves...

Profitability in relation to investment - Profitability Ratio a) Return on Investment (ROI) or return on total asset (ROTA) = (Net profit/ Total asset) x 100 The ratio i

Financial statement, Review the budget below and answer the questions follo...

Review the budget below and answer the questions following the budget. FINANCIAL ACCOUNTING—STATEMENT OF REVENUE AND EXPENSES Statement of Revenue and Expenses for Group Practice f

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