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 2 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 14 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 5 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 limitations of WACC as a discount rate 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 + 0.05 )

= 1.2 * 1.05

= 1.26

= [ 1.26/ 30 ] + 0.05

= 0.042 + 0.05

= 0.920

= 9.20%

WACC:

Source	Market Value(in M)	Weight	Cost	After Tax Cost	Wtd Cost
Debt1	$                     240.00	0.2791	5%	3.00%	0.84%
Debt2	$                     160.00	0.1860	6.50%	3.90%	0.73%
Preference Shares	$                       40.00	0.0465	7.50%	7.50%	0.35%
Common Stock	$                     420.00	0.4884	9.20%	9.20%	4.49%
WACC	6.40%

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.

Part B:

WACC is single rate and Cashflows of different years may need to discount at diff rates. As result of this we may accept the project with -Ve NPV.