Managerial accounting principles and applications

Managerial Acctg

The weighted average cost of capital is as follows:

In a net present value analysis, the cost of capital is often used as the discount rate. A net present value analysis seeks to reflect the value today of cash flows in the future. In order to do that, the future cash flows must be discounted back to present day dollars. There are a number of different ways to obtain the discount rate. The company might utilize a hurdle rate that they choose given their own reasons. Another approach is to use the rate associated with the financing that the firm wants to use -- for example if it intends to issue a bond it might use that bond rate as the hurdle rate. However, the weighted average cost of capital (WACC) is one of the most common.

The WACC is often adjusted to suit the risk profile of a given project. The WACC in that way serves as the base for determining the hurdle rate for a project. The WACC is then adjusted for project- or asset-specific risk factors such as the market, foreign factors or demand conditions. No matter what the adjustment that is made, however, the WACC is used in the same way when applied to the net present value calculation.

The reason that the WACC is used in the NPV calculation as the discount rate is because the WACC reflects the firm's rate of return. Under normal circumstances, a company should only undertake projects that offer it an opportunity to increase its value. Such projects would theoretically have a return that is greater than the cost of ongoing operations. The WACC reflects the cost of ongoing operations. When the WACC is used in a net present value calculation, any result of zero means that the project has a better rate of return than the firm's ongoing operations (Investopedia, 2012).

In an internal rate of return analysis, the weighted average cost of capital plays a similar role. In the calculation, the role is identical in that the WACC is used to discount the future cash flows to present-day dollars (Investopedia, 2012). It is the interpretation of the results where the WACC's relationship to the IRR differs from its relationship to NPV. The WACC represents the IRR of the company. Any project with an IRR higher than the IRR of the company is a project that adds value to the firm. Any project with an IRR lower than the IRR of the company does not add value to the firm. Thus, the IRR is compared directly to the WACC in an IRR analysis.

Task 5 1a) I would not buy this stock at its current price of $24/share.

1b) There are several reasons for this. The first reason is that this is a very high multiple. The P/E of this stock is 94.22, which is a multiple normally reserved for a very high growth company. This company saw its revenue shrink last year, so it clearly does not quality as a high growth company. The second reason is that the book value of the common stock is only $3.30 per share. The difference between the book value and the market value is substantial, which leads me to believe that the market price is unwarranted. The third reason I would not buy this stock at $24 is that the company's debt is increasing, while the value of its equity is decreasing. This is entirely the wrong direction in terms of financial health for a company with that type of multiple.

2a) Based on the company's current performance I would sell my shares in the company's stock.

b) The first reason that I would sell my shares is that the multiple is very high. It is important to sell stock when it is overvalued, in order to avoid taking losses when the stock price falls. The financial data and P/E ratio indicate that the value of this stock is going to fall. The second reason is that the firm's performance is declining. Revenues, gross profit, and net income all declined last year. As an equity investor, I want to own a stock that is going to increase in value and this company does not look like a company that will deliver that to me. The third reason for wanting to sell this stock is the company's return on equity. The return on equity right now is 3.2%, which is not a very high number. Most firms have better ROEs and as an investor, given the high price of the stock, such as ROE is a red flag that the price will not stay high much longer.

c) As a short-term creditor, I would approve the request for the line of credit. While I would have some reservations about the decline in the company's financial performance in the past year, this company is very liquid, and it is liquidity with which I am concerned. The first reason I would approve the loan is that the company's current ratio is 6.74%. While this figure is down dramatically from the year previous, it is still a great number. The second reason is the asset-test ratio, which is also very high at 5.48%. These figures, which derive from the company having significant amounts of cash on the books and hardly any current liabilities, mean that the company will not have any problems meeting its financial obligations over the short-term.

I would also look at the operating variables, including the days' receivable and the days' inventory. These items tell how the company is converting its current assets into cash. As a short-term creditor I want to see this conversion be quick. The receivables turnover is not as strong as I would like, but it is in the one-month range that is common in many businesses. The inventory turnover is less than one month. The high level of current assets, therefore, is not due to an excessive buildup of either accounts receivable or inventories; it is attributed instead to high level of cash, which is 19.1% of total assets.

d) As a loans officer, I would approve a long-term line of credit but I would need a higher rate of interest and some restrictive covenants in order to make this approval. There are a few reasons for this. The first is that the lousy year the company had last year might be an anomaly. I would want to perform my due diligence on this company to make that determination, but short-term challenges are precisely why companies need lines of credit, so I cannot hold that against them.