FIN 6060: FINANCIAL DECISION MAKING

MILESTONE 1 ASSIGNMENT: CALCULATING THE COST OF FINANCING

MBA LEARNER

NEXFORD UNIVERSITY

JUNE 2022
 FIN 6060: Financial Decision Making
Module 3 - Calculating the Cost of Financing Worksheet (Milestone 1)

Calculating the Cost of Financing

Step 1. Calculate the weighted average cost The weighted average cost of capital (WACC) is a central topic in financial management
of capital using the after-tax cost of debt and courses because of its usefulness in capital budgeting and business valuation
a required rate of return for stock of 5% for calculations.
each of the three years. Using the after-tax cost of debt and a required rate of return for stock of 5% for the years
2021, 2020, and 2019 accordingly, the Weighted Average Cost of Capital (WACC) for
Note: The tax rate can be found by dividing General Motors is calculated as shown below;
taxes paid by the taxable income. The pre-tax
cost of debt can be found by dividing the
interest paid by the amount of debt WACC is calculated as
outstanding (E/V * Re) + ((D/V * Rd) * (1-T))

Required pace of Return for stock (Re) = 5%

Charge rate(T) = Taxes paid

_______________
Taxable Income

2021 = $2,771million
______________ = 0.22
$12,716million

2020 = $1,774million
______________ = 0.22
$8,095million

Page 1 of 9
 FIN 6060: Financial Decision Making
Module 3 - Calculating the Cost of Financing Worksheet (Milestone 1)

2019 = $769million
_________________ = 0.10
$7,436million

Pretax cost of debt (Rd) = interest paid

___________________
measure of exceptional obligation

2021 = $8,582million
_______________ = 0.082
$104,495million

2020 = $11,274million
__________________ = 0.107
$105,607million

2019 = $12,614million
________________ = 0.069
$182,080million
Value Value(E)

2021 = $65,815million

2020 = $49,677million

2019 = $45,957million

Page 2 of 9
 FIN 6060: Financial Decision Making
Module 3 - Calculating the Cost of Financing Worksheet (Milestone 1)

Obligation Value(D)

2021 = $104,495million

2020 = $105,607million

2019 = $182,080million

Absolute Capital Value(V)

2021 = $170,310million

2020 = $155,284million

2019 = $228,037million

E/V * Re
2021 = 0.019

2020 = 0.016

2019 = 0.010

D/V * Rd * (1-T)

2021 = 0.039

Page 3 of 9
 FIN 6060: Financial Decision Making
Module 3 - Calculating the Cost of Financing Worksheet (Milestone 1)

2020 = 0.057

2019 = 0.0495

WACC = (E/V * Re) + ((D/V * Rd) * (1-T))

Where, WACC is the weighted typical expense of capital.

E is the market worth of the company's value.

D is the market worth of the company's obligation.

E/V is the level of capital that is value.

D/V is the level of capital that is obligation.

Re is the expense of value.

Rd is the expense of obligation.

T is the duty rate.

WACC

2021 = 0.058

Page 4 of 9
 FIN 6060: Financial Decision Making
Module 3 - Calculating the Cost of Financing Worksheet (Milestone 1)

2020 = 0.073

2019 = 0.060

General Motor’s Weighted Average Cost of Capital, for 2019,2020,2021 is shown below;

2019 = 6%

2020 = 7.3%

2021 = 5.8%

Step 2. Calculate the expected return of GM’s The capital asset pricing model (CAPM) is widely used in applications such as estimating
stock the using the Capital Asset Pricing the cost of capital for firms and evaluating the performance of managed portfolios (Farmer
Model. Use 1% as the risk-free rate, 1.3 as β, & French, 2004). For more than four decades, it has served as the gold standard for asset
and 5% as the expected market rate. pricing models, calculating asset returns and the cost of capital (Shih, Y., et al, 2014).

GM’s Expected Return using the Capital Asset Pricing Model (CAPM)

To calculate the General Motor’s Expected Return using the Capital Asset Pricing Model
(CAPM)

CAPM is calculated as:

Ra = Rrf + ((Ba * (Rm – Rrf))

Page 5 of 9
 FIN 6060: Financial Decision Making
Module 3 - Calculating the Cost of Financing Worksheet (Milestone 1)

where
Ra is the normal profit from a security.

Rrf is the risk-free rate.

Ba is beta of the security.

Rm is the normal return of the market.

Ra = 0.01 + ((1.3 * (0.05 - 0.01))

Ra = 0.01 + (1.3 * 0.4)

Ra = 0.01 + 0.052

Ra = 0.062

= 6.2%

General Motor’s Expected Return using the Capital Asset Pricing Model (CAPM) is 6.2%.

Step 3. Compare the weighted average cost The following is obtained by comparing the return and the weighted average cost of capital
of capital (WACC) with the return using the (using the capital asset pricing model):
Capital Asset Pricing Model (CAPM). What Weighted Average Cost of Capital Capital Asset Pricing Model
does your comparison indicate? It is the average rate a firm wants to It calculates the relationship between
finance its assets. systematic risk and expected asset return.

Page 6 of 9
 FIN 6060: Financial Decision Making
Module 3 - Calculating the Cost of Financing Worksheet (Milestone 1)

Debt and equity capital structures are To determine the cost of borrowing, it
analyzed to ascertain the total financing simply examines the equity capital structure.
cost.
It covers systematic and nonsystematic It focuses solely on systemic risk.
risks.

WACC is calculated in order to weigh the proportion of a company’s debt to its capital, it
helps a business to determine its level of debts in direct comparison to its capital while
CAPM is calculated to show relationship between the expected return and the risk of
investing in a security.
If a firm's returns are lower than its WACC, it is not profitable.(Segal,2022) In general, a
higher WACC is a sign of a firm with higher risk, while a lower WACC is a sign of a firm
with lower risk. (Segal, 2022)
GM has WACC of 5.4% . GM’s expected return using CAPM is 6.2% which is greater
than its WACC indicates that investing in security has a lower risk as expected return is
higher than cost of capital.

Step 4. What does a β of 1.3 mean? Beta measures the volatility and systematic risk of a stock. According to the CAPM theory,
beta is always proportionate to an increase in premium in a given market (Soumya S.,
2021).
The stronger the beta, the greater the volatility of the stock; the lower the beta, the lower the
volatility of the stock. A positive beta number indicates that stocks and the market move in
the same direction, and vice versa. Therefore, a Beta value of 1.3 shows that the stock is
30% more volatile than the market as a whole.

Step 5. Assess the risk of investing in GM General Motors' risk is moderate.

Page 7 of 9
 FIN 6060: Financial Decision Making
Module 3 - Calculating the Cost of Financing Worksheet (Milestone 1)

stock compared to the market. Would you The stock price of GM has fluctuated throughout the previous few years. GM's market
recommend investors to purchase the share has increased with a forecast return on its securities of 6.2%.
company’s stock? Why or why not? The beta value of 1.3 indicates that the firm's stock is 30% more volatile than the market.
It is advised that investors purchase the company's stock as the risk is low. The company is
striving to stabilize its stock and despite its stock's volatility, the stock is pretty steady.

REFERENCES
Berry, S.G., Betterton, C., Karagiannidis I., (2014, January). Understanding Weighted Average Cost of Capital: A Pedagogical Application.
Journal of Financial Education (0093-3961). Retrieved on May 20th, 2022 from
https://www.researchgate.net/publication/289530651_Understanding_Weighted_Average_Cost_of_Capital_A_Pedagogical_Application

Fama, E. F., & French, K. R. (2004). The capital asset pricing model: Theory and evidence. The Journal of Economic Perspectives, 18(3), 25-
46. Retrieved from https://fl31ftr5a-mp01-y-https-www-proquest-com.proxy.lirn.net/scholarly-journals/capital-asset-pricing-model-theory-
evidence/docview/212090442/se-2

Shih, Y., Chen, S., Lee, C., & Chen, P. (2014). The evolution of capital asset pricing models. Review of Quantitative Finance and
Accounting, 42(3), 415-448. doi: https://fl31ftr5a-mp01-y-https-doi-org.proxy.lirn.net/10.1007/s11156-013-0348-x

Page 8 of 9