Overview of the company
“Praxair is a global Fortune 300 company that supplies atmospheric, process and specialty gases, high performance coatings and related services and technologies” (Praxair Technology Incorporation 1). Some of the gases supplied by the company are oxygen, nitrogen, argon, carbon dioxide, helium and hydrogen. These gases are used as inputs in about 25 industries such as food processing companies, hospitals and in the production of computers among others. The company has presence in over 50 countries. In addition, it owns about 3000 patents (Thomson Reuters 1). It has over 26,000 employees. Founded in 1907, Praxair is a public company trading on the New York Stock Exchange. In 2011, the company had revenue amounting to US$11. 25 billion. 94% of these sales were generated in four geographical segments. These are North America, Europe, South America, and Asia (Thomson Reuters 1). The net income for the same period amounted to US$1.67 billion. Diluted earnings per share for the same period amounted to $5.45 and cash dividend per share totaled to $2. Praxair is a renowned company in sustainable development. It is as a result of various corporate social responsibilities they undertake which target on sustainable growth (Praxair Technology Incorporation 1). This paper calculates the cost of debt, cost of equity, weighted average cost of capital and asset beta.
Cost of debt
Debt is a component of a company’s capital structure. A number of firms consider it as a cheap source of finance. It is based on the fact that debt attracts predetermined rate of interest which is payable at a fixed period of time. A company’s cost of debt is based on the cost of bonds. Bonds are sources of long term debt for a firm. In most cases, they are preferred to bank loans. When calculating cost of debt of a company, it is important to use recently issued bonds because they reflect the fair rate possible than older bonds. However, when the company has not issued bonds, it can use the cost of debt for companies in the same industry. It is imperative to note that the cost of underwriting the bonds and floatation costs are ignored in calculation of the cost of the bond since they are regarded as immaterial (Financial Industry regulatory Authority 1). The interest on bonds are tax deductible, therefore, necessary adjustments should be made at the coupon rate using the tax rate. The cost of debt is the rate a company pays on its debt. The cost of debt for Praxair Inc. is 6.70%. The computation is based on the assumption that the company issued twelve bonds. Further, it uses an average tax rate for the past five years and not for a single year. It is for the reason that the bonds were issued after a several years and not a single year (Pratt and Grabowski 326)
Cost of equity
Cost of equity denotes the annual rate of return investors anticipate to make from investing in shares of a company. The return investors expect at the end of the year comprises of two elements these are, the fluctuations (positive of negative) on the market price of the shares and the dividends paid by the company. Cost of equity is a central element of stock valuation because shareholders expect their shares to grow annually at the rate of cost of equity. In addition, the cost of equity is used in calculating the fair value of an investment in a company. There are two models that are commonly used for calculating the cost of equity. There are the dividend growth model and the capital asset pricing model. Dividend growth model is the easiest to use though it assumes that the dividends paid for by the company grows at a constant rate. The assumption is unrealistic. Therefore, the second method is commonly preferred. Rate of return on risk free securities, beta of the investment in question and the market’s overall expected rate of return are required for computation of cost of equity using the capital asset pricing model. For this analysis, the capital asset pricing model is used to compute the cost of capital. The analysis makes use of historical data of the company and industry averages in the computations. The cost of equity for the company is 10.10%. The assumption on use of industry averages is realistic because the values of the industry are computed from the values of the firms in that industry (Brigham and Daves 129).
Weighted average cost of capital
Weighted average cost of capital is neither cost of debt nor the cost of equity. It is an average rate that a company should pay to fund its assets. Alternatively, it is the rate of return which a firm must make from the assets to satisfy the financers of the company, there are the shareholders and creditors. A company receives from various sources. The Weighted average cost of capital takes into account the relative weights of each component in the capital structure of the firm. This shows that one must have required rate of return for each component of the capital structure. This facilitates the calculation of the weighted average rate cost of capital. In most cases, the individual firm’s weighted average rate cost of capital is different from that of the industry. However, over time the weighted average rate cost of capital for all firms in the industry should converge to the industry weighted average rate cost of capital. The weighted average cost of capital for the company is 9.1%. The inputs for the weighted average cost of capital are risk free rate, cost of debt, equity risk premium, value of alpha, beta, the tax rate and cost of equity. The tax rate is assumed to be an average of five years (Hitchner 266).
Asset beta is used in the capital asset pricing model. It measures the volatility of a company’s stock relative to the market changes. Computation of asset beta is founded on historical returns which may not give an estimate of the firm’s future share prices. A number of factors can make the value of asset beta to fluctuate. Some of the factors are risk of the business, operation risk, financial risk, and sales risk. Asset beta is the sum of beta equity and beta debt (Pratt 56). The firm’s asset beta is 0.93. The value can be incorporated in the capital asset pricing model to get the unlevered cost of capital. Unlevered cost of capital refers to the cost of capital if the firm does not have debt in its capital structure. The unlevered cost of capital is 8.0%.
Brigham, Eugene, and P. Daves. Intermediate Financial Management, United States of America: Cengage learning, 2009. Print.
Financial Industry regulatory Authority 2012, Market Data. Web.
Hitchner, James. Financial Valuation: Applications and Models, United States of America: John Wiley & Sons, Inc., 2011. Print.
Pratt, Shannon, and R. Grabowski. Cost of Capital: Applications and Examples, United States of America: John Wiley & Sons, Inc., 2010. Print.
Pratt, Shannon. The Lawyer’s Business Valuation Handbook: Understanding Financial Statements, United States of America: ABA Publishing, 2003. Print.
Praxair Technology Incorporation. 2012, About Praxair. Web.
Thomson Reuters 2012, Profile: Praxair Inc (PX). Web.