Question

(i) Boral currently has $400 million market value of debt outstanding. This debt was contracted five years ago at the rate of 4%. Boral can refinance 60% of the debt at 5% with the remaining 40% refinanced at 6.5%. The company also has an issue of 6 million preference shares outstanding with a market price of $20 per share. The preference shares offer an annual dividend of $1.5 per share. Boral also has 10 million ordinary shares outstanding with a price of $30.00 per share. Boral just paid a $1.2 ordinary dividend, and that dividend is expected to increase by 6 per cent per year forever. If the corporate tax rate is 40 per cent, calculate Boral’s weighted average cost of capital (WACC).

(ii) Discuss the alternatives to using WACC for evaluating new projects.

Answer 1

WACC is weighted Avg cost of sources in corporate structure.

COst of Preference share = Pref DIv/ Price

= $ 1.5 / $ 20

= 7.5%

COst of Equity = [ D1 / P0 ] + g

D1 = D0 ( 1 + g )

= 1.2 ( 1 + 0.06 )

= 1.2 * 1.06

= 1.272

= [ 1.272/ 30 ] + 0.06

= 0.0424 + 0.06

= 0.1024

= 10.24%

WACC:

Source	Market Value(in M)	Weight	Cost	After Tax Cost	Wtd Cost
Debt1	$                     240.00	0.2927	5%	3.00%	0.88%
Debt2	$                     160.00	0.1951	6.50%	3.90%	0.76%
Preference Shares	$                     120.00	0.1463	7.50%	7.50%	1.10%
Common Stock	$                     300.00	0.3659	10.24%	10.24%	3.75%
WACC	6.48%

After Tax cost of Debt = Cost of Debt * ( 1 - Tax Rate )

Prefernce div and Equity div after below line Items hence tax benifit will not be available. Thus before tax cost and after tax cost are same.