Essays on Alternative Stock Valuations And Cost Of Capital Based On Firm Capital Structure Assignment

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Company Profile: Origin Energy Limited: Company Valuation (Alternatives): Valuation of Origin Energy is done using various techniques and methods. Initially the valuation is done using free cash flow to firm under constant growth model and multi-stage growth model. Then, valuation is done using several multiples such as Price-earning, price-book values and others. For valuation Weighted Average Cost of capital is used. WACC: Weighted Average Cost of Capital is the firm’s average cost to employ its capital in running the business. A firm generates capital primarily from two sources, shareholder’s capital and borrowed capital. Different risks are attached with generating capital from both the sources which results in different expected return from employing the funds.

These expected returns from the stakeholders become the cost for the firm. This cost for the firm is known as the average cost of capital employed in the business. Since average cost of capital is a weighting of its cost of equity and its cost of debt, it is usually referred to as the weighted average cost of capital. WACC = (S/(S+B)) * rs + (B/(S+B)) * rb * (1 – Tc)Where, S is shareholder’s equity, B is borrowed capital, rs is cost of equity, rb is cost of debt and Tc is effective tax rate.

To calculate WACC for Origin Energy Limited following factors must be analyzed. Capital Structure of Origin Energy Limited: The capital structure of the firm estimate its gearing level, which shows how much own fund and loan fund is employed in the business. Three ratios are useful in assessing the capital structure of a firm namely Debt-to-Capital Ratio, Debt-to-Equity Ratio and Equity Multiplier. Debt-to-Capital Ratio: This reflects the ratio of total long term debt to total capital employed.

For Origin Energy (Year 2008) it is calculated as following (Thomson One Banker): D-C Ratio = Total Debt/Total Capital = . 27Debt-to-Equity Ratio: It reflects the total proportion of debt as comparison to equity in the firm’s capital. D-E Ratio = Total Debt/Total Equity = . 37Equity Multiplier: It is the ratio of total assets to total equity. Equity Multiplier = Total Assets/ Total Equity = 1.34Analysis of these ratios for Origin Energy shows that the firm’s debt level is at lower side. Hence the firm has significant debt capacity unutilized.

Only 28% of total capital employed is funded from debt activities. While debt is just 37% of total equity invested. Cost of Equity: From the firm’s perspective, the expected return is the cost of equity capital. Under CAPM, the expected return on the stock is (Ross, Wetserfield and Jaffe): rs = RF + β * (RM – RF)Where, RF is risk free rate of return, β is beta of the stock and RM is the market return. The beta value for Origin Energy is estimated to be. 66 which is calculated by regressing the past one year returns of stock over the market return (using index Australian Stock Exchange) for the same period.

In Australia the risk premium is at medium level which is estimated to be around 7.5%. Risk free rate for the firm is assumed to be at 5% level. This gives the value of cost of equity for Origin Energy as following:

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