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 percent 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 = weighted average of cost for various sources of capital where the weights are market values for the sources of capital

market value of equity = 10*30=300

market value of preference shares = 20*6 = 120

market value of 60% of debt =400*0.6 = 240

market value of 40% of debt = 400*0.4 = 160

cost of equity = dividend yield + growth = 1.2 * 1.06 / 30 + 0.06 = 10.24%

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

total market value = 400+300+120 = 820 m

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

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

= 6.50%

(ii)

limitations of WACC as a discount rate for evaluating new projects are :

1) It is not necessary that the project is financed with the same mix of debt / equity/ preference with whom we have calculated the wacc. Hence the wacc wont be the correct discount rate for the projects.

2) Also its not necessary that the risk of the project will be same as risk of the company hence the wacc wont be the appropriate discount rate to be used for new projects.