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

Future value of single or multiple cash flows, Do your experts provide Futu...

Do your experts provide Future Value of Single or Multiple Cash Flows assignment help? I need urgent help in my college assignment.

Present value of an annuity - dcf technique, Present Value of an Annuity - ...

Present Value of an Annuity - DCF Technique An individual investor may not necessarily acquire a lump sum after several years however rather obtain a constant periodic amount

The importance of tax, Discuss business taxes and their importance in finan...

Discuss business taxes and their importance in financial decisions

Calculate the weighted average cost of capital, Company XYZ stock is consid...

Company XYZ stock is considering the two new projects, Project A and Project B. The two projects have similar risk characteristics as the existing business. The managers forecast t

Financial markets, what are the main function of the derivative market

what are the main function of the derivative market

Present value of a lump sum - dcf technique, Present Value of a Lump Sum - ...

Present Value of a Lump Sum - DCF Technique Generally an investor would want to know how much he or she would stop currently to get a provided amount in year 1, 2, ... n.  In

Constant payout ratio, Constant payout ratio 1. This is whereas the fi...

Constant payout ratio 1. This is whereas the firm will pay a fixed dividend rate as like 40 percent of earnings. The DPS would consequently fluctuate as the earnings per share

Example of debt finance, Example of Debt Finance An example: Intere...

Example of Debt Finance An example: Interest = 10% tax rate = 30% The effective cost of debt (interest) = Interest rate (1 - T) = 10%(1-0.30) = 7% Consider comp

Management of sole proprietorship, Management of Sole Proprietorship  I...

Management of Sole Proprietorship  In sole proprietorship the owner is usually in charge of day to day running of the business. If the business is large he may give some duties

Debtors collection period - formula, Debtors Collection Period - Formula ...

Debtors Collection Period - Formula Fomula is given below: Debtors collection period = 365/ Debtors turnover Or (365 x Average debtors)/ Annual credit sales This

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