Question

The CFO of a manufacturing firm is determining the capital budget. Currently the market value of the firm' equity and debt are $8 billion and $10 billion, respectively. The company’s debt trades with a yield to maturity of 8%, and its equity has an expected return of 14%. The firm’s marginal tax rate is 30%.

The projects that are under consideration have different risk and returns. The company estimates that low-risk projects have a cost of capital of 8% and high-risk projects have a cost of capital of 14%.

Project                Expected Return                   Risk

A 15% High

B 13% Average

C 12% High

D 10% Low

E 7% Low

(a) Compute the company’s weighted average cost of capital (WACC).

(b) The Finance Manager suggests to invest in projects which expected rate of returns are higher than the firm’s WACC. Do you agree with the Finance Manager? Justify your answers with reference to the use of WACC.

(c) To maximize shareholder wealth, which of the projects should the CFO select to invest in? Evaluate each project separately and provide the justification.

Answer 1

1. Formula for computing WACC

WACC = W_e*R_e + W_d*(R_d*(1-t))

Where

W_e = weight of equity

R_e =cost of equity

W_d = weight of Debt

R_d = Cost of debt

t = Tax rate

We have been given

W_e = 55.56% (calculated in excel)

R_e =14% (given as expected return on equity)

W_d = 44.44% (calculated in excel)

R_d = 8% (given as yield to maturity)

t = 30% (given)

Working in excel

WACC = 10.27%

2. Finance manager is right when he say we should invest in projects which have higher expected return than WACC. WACC is the overall cost of financing a project and to make profit our cost should always be less than our return. In our case we have 5 projects with various expected return and risk. Our WACC as calculated above is 10.27%.

Project A has expected return of 15% and high level of risk when we compare it with our WACC we can expect a profit margin of 4.73% (15% - 10.27%)

Similarly project B and C have expected profit margin of 2.73% (13% - 10.27%) and 1.73% (12% - 10.27%) respectively

Project D and E have an expected profit margin as -0.27% (10% - 10.27%) and -3.27% (7% - 10.27%) respectively both these have negative profit margins (loss) when compared to cost i.e. WACC

3. To maximize shareholders Profit Company should invest in project which gives them maximum return from the available options.

Let’s compare the returns and company’s estimate of cost of capital for high risk project of 14% and low risk project of 8%

Project B has Average risk profile so we use WACC to compare as company has not given any information on average risk profile; still we need to compare it with a cost.

From the working above let’s compare each project

Project A is high risk project and expected profit margin is 1%, Project C is also high risk but expected profit margin is -2% (loss). If the company has only these 2 options then Project A should be selected as it gives profit.

Project D and E both are low risk and expected return for both are 2% and -1% respectively. If there are no other options available we would select Project D as it is profitable.

For Project B the risk profile is Average so we are comparing it with Average return which is our WACC. Based on it the projected is expected to give 2.73% profit.

If we compare all 5 projects, 3 are profitable and 2 are loss making. In order to maximize shareholder Profit Company should select profit making project, out of the 3 profit making projects Project B is giving maximum return with an average risk. This suits both the company and shareholders interest, by taking average risk if company can maximize the profit than that’s the project to be selected.

So we select Project B from all of above.