With markets all over the World falling sharply in the last month or so, taking cue from decline in Chinese growth and other geopolitical factors, it is argued that the resiliency in US market may be underestimated by market players (Ydstie, 2016).
In American Chemical case, we did not use the cost of loan at 11.25% to discount the future cash flows and instead used WACC, as the target capital structure is used as discount rate and not the current or used capital structure. In this transaction, Dixon may have decided to fund the purchase entirely through the debt capital, but the company would use the target capital ratios between debt and equity for its other transactions, and also for future transactions involving the plant.
The choice of risk free rate is an important one and a wrong choice can alter the final results significantly. While it has been argued that using year specific risk free rates is the best way to go, it poses a challenge from the practical standpoint and may not be worth the effort (Damodaran, 2008, p.9).
While for mature markets and companies, using 10 year government bond yield would make sense, for higher growth companies and markets, using 30 year government bond yield is better. In actual market however, there is not much difference between the rates of 10 year government bond and 30 year government bond, so we for simplicity we may use the 10 year government bond yield as the risk free rate.
For taking debt and equity weights while calculating WACC, target debt/ equity ratio at market value should be used (Investopedia). Target debt to equity ratio should be used as a company would move towards that capital structure in future and the investors’ future cash flows would depend on future or target capital structure and not the current one. Also, market value of debt and equity should be used instead of book value as the return that investors would get for investing the money would be on the market rate and not the book value of assets.
As the funds would be used for the business in Dusseldorf, Germany, the German 10 year bond yield should be used.
Reference List
Ydstie, J., 2016. Analysts: Markets May Be Underestimating U.S. Economic Resilience. National Public Radio. [online] Available at: <http://www.npr.org/2016/01/25/463968800/analysts-markets-may-be-underestimating-u-s-economic-resilience> [Accessed 26 January 2016].
Damodaran, A. 2008. What is the riskfree rate? A Search for the Basic Building Block. [online] Available at: <http://people.stern.nyu.edu/adamodar/pdfiles/papers/riskfreerate.pdf> [Accessed 26 January 2016].
Folger, J. What is the formula for calculating weighted average cost of capital (WACC)? Investopedia. [online] Available at: <http://www.investopedia.com/ask/answers/063014/what-formula-calculating-weighted-average-cost-capital-wacc.asp> [Accessed 26 January 2016].
