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 = weighted average of the cost of various components of capital where the weights are the proportion of the capital to the total capital

Market value of debt = $400m

cost for 60% ie 400*60% (240 m ) = 5%

cost for 40% ie 400*40% ( 160 m) = 6.5%

market value of equity = 10*30=300

cost of equity = Dividend next year / price + growth = 1.2*1.06 / 30 + 0.06 = 10.24%

cost of preference equity = dividend / price = 1.5/20 = 7.5%

market value of preference shares = 6*20 = 120

Total market value = 400 +300 +120 = 820

wacc = weight of debt * cost of debt *( 1 - tax rate ) + cost if equity * weight of equity + cost of preference share * weight of preference

= 240/820 * 5 * 0.6 + 160/820 * 6.5*0.6 + 300/820*10.24 + 120/820 * 7.5

= 6.50%

Many a times wacc does not reflects the risk involved in the project hence we need to use risk adjusted discount rates to take care of the risk inherent in the projects. So the risky cashflows needs to dicounted at the risk adjusted retrun rather than the weighted averge which is just based on the market value weights of different sources of capital.