Question

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

i]	The first step is to find the cost of the component
	sources of capital structure.
a]	Cost of debt:
	The average before tax cost of debt = 5%*60%+6.5%*40% =	5.60%
	After tax cost of debt = 5.60%*(1-40%) =	3.36%
b]	Cost of preferred capital = 1.5/20 =	7.50%
c]	Cost of common equity = 1.2*1.06/30+0.06 =	10.24%
d]	WACC [using market value weights] is calculated in the table below:
	Component	Market Value in million $	Weight	Component Cost	WACC
	Debt [MV as given]	$           400.00	48.78%	3.36%	1.64%
	Preferred stock [MV = 6m*$20]	$           120.00	14.63%	7.50%	1.10%
	Common stock [10m*$30]	$           300.00	36.59%	10.24%	3.75%
	Total	$           820.00			6.48%
	WACC = 6.48%
b]	The WACC, as determined above, can be used to evaluate capital expenditure projects of the firm if, the new
	projects have the same risk as the existing business. But, if the new investements have higher or lower risks
	when compared to the existing business of the firm, the WACC should be adjusted upwards or downwards to
	reflect the higher or lower risk of the projects, as the case may be.