Project for Intrinsic Value

Introduction summary of project

Given research paper are the calculation of risk, expected return of portfolio and the calculation of intrinsic value of the stock price based on the weighted average cost of capital. The company selected here is Procter and Gamble (PG). The intrinsic value is calculated through the WACC by CAPM model.

Further it is the comparison of intrinsic value with the current market price of the share based on the CAPM model. The intrinsic value is calculated by capital asset pricing model. A portfolio is also constructed here wherein the two stocks are compared i.e. the shares of PG and the other company JNJ (Johnson and Johnson).

The cost of capital is the required rate of return that a firm must achieve in order to cover the cost of generating funds in the marketplace. It is calculated by adding up all the cost of equity and preferred stock and common stock. Based on this cost, WACC is calculated and thereby intrinsic value of share. The portfolio is the comparison of two assets for investing.

The cost of capital is the required rate of return that a firm must achieve in order to cover the cost of generating funds in the marketplace. Based on their evaluations of the riskiness of each firm, investors will supply new funds to a firm only if it pays them the required rate of return to compensate them for taking the risk of investing in the firm's bonds and stocks. If, indeed, the cost of capital is the required rate of return that the firm must pay to generate funds, it becomes a guideline for measuring the profit abilities of different investments. When there are differences in the degree of risk between the firm and its divisions, a risk-adjusted discount-rate approach should be used to determine their profitability.

The firm must earn a minimum of rate of return to cover the cost of generating funds to finance investments; otherwise, no one will be willing to buy the firm's bonds, preferred stock, and common stock. This point of reference, the firm's required rate of return, is called the COST OF CAPITAL. The Cost of Capital becomes a guideline for measuring the profit abilities of different investments.

Another way to think of the cost of capital is as the opportunity cost of funds, since this represents the opportunity cost for investing in assets with the same risk as the firm. When investors are shopping for places in which to invest their funds, they have an opportunity cost. The firm, given its riskiness, must strive to earn the investor's opportunity cost. If the firm does not achieve the return investors expect (i.e. the investor's opportunity cost), investors will not invest in the firm's debt and equity. As a result, the firm's value (both their debt and equity) will decline. The goal of the corporation is to maximize the value of shareholders' equity!

WEIGHTED AVERAGE COST OF CAPITAL

(WACC)

The firm's WACC is the cost of Capital for the firm's mixture of debt and stock in their capital structure.

WACC = wd (cost of debt) + ws (cost of stock/RE) + wp (cost of pf. stock)

So now we need to calculate these to find the WACC!

wd = weight of debt (i.e. fraction of debt in the firm's capital structure)

ws = weight of stock

wp = weight of preferred stock

COST OF DEBT (Kd)

We use the after tax cost of debt because interest payments are tax deductible for the firm.

Kd after taxes = Kd (1 – tax rate)

We use the effective annual rate of debt based on current market conditions (i.e. yield to maturity on debt). We do not use historical rates (i.e. interest rate when