Question

The management of Ethan plc is trying to decide on a cost of capital to apply to the evaluation of investment projects. The company has an issued share capital of 500,000 ordinary K1 shares, with a current market value cum-div of K1.17 per share. It has also issued K200,000 of 10% debentures, which are redeemable at par in five years’ time and have a current market value of K105.30 cum-interest, and K100,000 of K1 irredeemable 6% preference shares, currently priced at K0.40 per share ex-div. The preference dividend has just been paid, and the ordinary dividend and debenture interest are due to be paid in the near future.
Management considers the current capital structure of the company to be similar to their plans for its long-term capital structure.
The ordinary share dividend will be K60,000 this year, and the Directors have published their view that earnings and dividends will increase by 5% a year into the indefinite future. The company pays tax at 25% per year in the same year as profits.
Required:
a) Calculate the WACC.
b) Discuss the importance of the cost of capital in project appraisal and highlight the impact
that a wrong discount rate would have on decision making.

Answer 1

a) Formula for WACC

WACC = W_d * (r_d * (1-Tax)) + W_ps * r_ps + W_e * r_e

W_d,W_ps &W_e – Weights of debt, preference shares & equity shares, respectively

r_d,r_ps & r_e   - Required returns debt, preference shares & equity shares, respectively

Calculation of market prices

Equity	Preference Share	Debenture
Market price per share cum-dividend = 1.17 per share Dividend = 60,000/500,000 = 0.12 per share Market price per share ex dividend = 1.17 – 0.12 = 1.05 per share Total market value of equity = 500,000 * 1.05 = 525,000 Now, P0 = D1/(re-g) Implying re = (D1/P0)+g D1(next yr div) = 0.12*1.05 = 0.126 P0 = 1.05 g = 5% Hence, re = (0.126/1.05)+0.05 = 0.17 = 17% Total equity, preference shares & Debenture = (525,000+40,000+19,060,000) = 19,625,000 We = 525,000/19,625,000 =2.68%	Dividend = 6% of 1= 0.06 Market price ex-dividend = 0.4 Total Market value = 100,000 * 0.4 = 40,000 rps = 0.06/0.4 = 15% wps = 40,000/19,625,000 = 0.20%	Market price cum-interest = 105.30 Market price ex-interest = 105.30 – 10 = 95.30 Total Market Value = 200,000 * 95.30 = 19,060,000 In calculator, put N=5, PV=-95.30 PMT=10 FV=100 to get I/Y = rd = 11.28% wd = 19,060,000/19,625,000 = 97.12%

Hence, WACC = W_d * (r_d * (1-Tax)) + W_ps * r_ps + W_e * r_e = 8.70%

b) Cost of capital is important in appraising the project because it provides an appropriate benchmark against which the returns of the prospective projects are evaluated and decisions are made. Let’s assume a wrong discount rate is taken which is lower than the required discount rate then this would increase the present value of the project cash flows which in turn would lead to selection of sub-optimal projects. On the other hand, if wrong discount rate is taken on higher side then it would lead to rejection of otherwise good projects.