What is the best way to minimize the weighted average cost

Question

Article Analysis: Forecasting Models

The article below file "Comparing the Accuracy and Explainability of Dividend" in the module resources will aid in your understanding of forecasting models to find the best way possible to determine cash flow, equity value, pricing, interest rate determination, and dividend allocation. This understanding will be necessary when completing Section VI of the final project.

Once you have read the article, answer the questions found in Module the Six Forecasting Models Research Questions document, also located in the Assignment Guidelines and Rubrics folder.

Module Forecasting Model Questions

The questions that follow and the articleComparing the Accuracy and Explainability of Dividend, Free Cash Flow, and Abnormal Earnings Equity Value Estimateswill inform your completion of milestone III. An understanding of the models in this assignment will assist you in hypothesizing the incremental impact of a new investment project for the company. The understanding of these models will contribute to your ability to look toward the future when considering the direction of an organization.

Prompt

Once you have read the article"Comparing the Accuracy and Explainability of Dividend, Free Cash Flow, and Abnormal Earnings Equity Value Estimates" and Chapters 6 and 7 of your text, review and complete the questions below. Use the article and your text to inform your responses to the questions below.

Assignment Questions:

1. For models 2, 2a, and 2b:

V_F^FCF = _t=1∑^T {FCF / (1 + r_WACC)^t} + ECMS_F - D_F - PS_F                             (2)

FCF_t = (SALES_t - OPEXP_t - DEPEXP_t) (1 - τ) + DEPEXP_t - ΔWC_t - CAPEXP_t     (2a)

r_WACC = ω_D (1 - τ)r_D + ω_PSr_PS + ω_Er_E                                                        (2b)

where:

V_F^FCF = market value of equity at time F;
SALES_t = sales revenues for year t;
OPEXP_t = operating expenses for year t;
DEPEXP_t = depreciation expense for year t;
ΔWC_t = change in working capital in year t;
ΔWC_t = capital expenditures in year t;
ECMS_t = excess cash and marketable securities at time t;
D_t = market value of debt at time t;
PS_t = market value of preferred stock at time t;
r_WACC = weighted average cost of capital;
r_D = cost of debt;
r_PS = cost of preferred stock;
ω_D = proportion of debt in target capital structure;
ω_PS = proportion of preferred stock in target capital structure;
ω_E = proportion of equity in target capital structure; and
τ = corporate tax rate.

• What is the best way to minimize the weighted average cost of capital?
• What is the effect of the weighted average cost of capital on the market value?

2. For models 3, 3a, and 3b:

V_F^AE = B_F + _t=1∑^T AE _t / (1 + r_E)^t       (3)

AE_t = X_t -  r_EB_t-1                                (3a)

B_t = B_t-1 + X_t - DIV_t                          (3b)

where:

V_F^AE = market value of equity at time F;

AE_t = abnormal earnings in year t;

B_t = book value of equity at end of year t; and

X_t = earnings in year t.

• What is the relationship between book value of equity and time t-1 and the market value of the equity?

3. Discuss model 4 and expand on the importance and the meaning of the market risk premium.

r_E =  r_f  + β[E(r_m) - r_f]                      (4)

where:

r_E = industry-specific discount rate;

r_f = intermediate-term Treasury bond yield minus the historical pre­mium on Treasury bonds over Treasury bills (Ibbotson and Sinquefield [1993]);

β = estimate of the systematic risk for the industry to which firm j belongs. Industry betas are calculated by avenging the firm-specific betas of all sample firms in each two-digit SIC code. Firm-specific betas are calculated using daily returns over fiscal year t - 1;

E(r_m) - r_f = market risk premium = 6%.

4. In your own words, what are the main conclusions for this article, and what could be improved upon in its analysis?