Question

1 pts

Stark Industries Ltd has financed its business using a simple capital structure of long-term debt and equity. A balance sheet extract for Stark Industries is given below:

Extract from Balance Sheet 30 June 2019

Liabilities

Debentures ($100 par, 4% p.a. semi-annual coupon)                     $1,000,000,000

Preference shares ($10 par, 10% semi-annual dividend)                   $500,000,000

Equity

Ordinary shares ($1 par)                                                                       $800,000,000

Retained earnings                                                                                 $200,000,000

Additional Information

• An interest payment in relation to the debentures has just been made, and they mature in eight years from today. The current yield on similar risk debentures in the marketplace is 6.00% p.a.
• Forecasts in relation to market returns are as follows: expected rate on 10-year Commonwealth Bonds = 3.25% p.a. compounded annually; expected return on the market portfolio = 9.75% p.a. compounded annually
• Stark Industries preference shares have a dividend yield of 10% every six months on a par value of $10. A dividend payment was made today. The beta of the preference shares is 1.4
• Stark Industries has a levered ordinary share equity beta of 1.7
• Stark Industries ordinary shares are expected to pay a dividend of $0.15 in exactly six months’ time and this dividend is forecast to grow at 2% every six months in perpetuity
• Both the preference shares and the ordinary shares pay a dividend each six-months
• The company tax rate is 30%
• Stark Industries Ltd operates in a classical tax system

REQUIRED:

1. Calculate the after-tax weighted average cost of Stark Industries Ltd. Show all calculations.
2. When could Stark Industries use this WACC for project evaluation? When shouldn’t it use it?

Answer 1

WACC is the average rate that a company is expected to pay to its stakeholders to finance its assets. In simple terms the minimum return that the firm should earn on the existing asset base so that the investors and lenders are interested or they will invest elsewhere. WACC is a calculation of a firm’s cost of capital in which each category is proportionally weighted.

WACC formula is as follow:

WACC = Cost of Equity * weights of equity + Cost of Debt *(1-Tax Rate)* weights of debt + Cost of Preference * weights of Preference

Cost of Equity

It is the return that shareholders expect in order to compensate for the risk they undergo when they invest their capital in the equity (stock). We can use CAPM model in such a scenario.

Cost of Equity = Rf+B*(Rm-Rf)

Rf - It is the return that can be earned by investing in riskless security (In this example it is 10-year Commonwealth Bonds)

Rm - Annual return on market ( In this example it is expected return on the market portfolio)

B - Equity Beta. It is the measure of the stocks volatility of return compared to a benchmark index (In this example ordinary share equity beta)

Calculation of cost of Equity based on data given

cost of equity = 3.25% + 1.7 * (9.75%-3.25%)

cost of equity = 3.25% + 1.7 * 6.5%

cost of equity = 3.25% + 11.05%

cost of equity =14.3%

Cost of Debt

It is predetermined rate that has been agreed on by the firm before issuing bonds to investors. In the formula there is an additional factor (1-T) multiplied by cost of debt, this is because there are additonal multiplications with these interest expenses.

In this example it is given as 4% interest rates

Cost of Preference

It is predetermined rate that has been agreed on by the firm before issuing preference shares to investors.

In this example it is 10%

Calculation of Weights of each investor

Total Capital = Equity + Debt + Preference

=(800000000+200000000) + 1000000000 + 500000000

=2500000000

Calculation of WACC

.WACC = Cost of Equity * weights of equity + Cost of Debt *(1-Tax Rate)* weights of debt + Cost of Preference * weights of Preference

=14.3% * ((800000000+200000000) / 2500000000) + 4% * (1-30%) * (1000000000 / 2500000000) + 10% * (500000000 / 2500000000)

=14.3% * 40% + 2.8% * 40% + 10% * 20%

=5.72% + 1.12% + 2%

=8.84%

After-tax weighted average cost of Stark Industries Ltd. is 8.84%.

This WACC company can use to calculate value of firm.

Company should not use this WACC for calculation of value for equity shareholders as this WACC is for all investors in company. So company should use cost of equity for calculation of value for its equity shareholders.