Question

Scenario: You work for an investment banking firm and have been asked by management of Vestor Corporation (not real), a software development company, to calculate its weighted average cost of capital, to use in evaluating a new company investment. The firm is considering a new investment in a warehousing facility, which it believes will generate an internal rate of return of 11.5%. The market value of Vestor's capital structure is as follows:

Source of Capital	Market Value
Bonds	$10,000,000
Preferred Stock	$2,000,000
Common Stock	$8,000,000

To finance the investment, Vestor has issued 20 year bonds with a $1,000 par value, 6% coupon rate and at a market price of $950. Preferred stock paying a $2.50 annual dividend was sold for $25 per share. Common stock of Vestor is currently selling for $50 per share and has a Beta of 1.2. The firm's tax rate is 34%. The expected market return of the S&P 500 is 13% and the 10-Year Treasury note is currently yielding 3.5%.

Determine what discount rate (WACC) Vestor should use to evaluate the warehousing facility project.

Assess whether Vestor should make the warehouse investment.

Answer 1

“Weighted Average Cost of Capital [WACC] = 9.09%”

Workings

Cost of Bond

=YTM = Coupon Amount + [ (Par Value – Bond Price) / Maturity Years ] / [(Par Value + Bond Price)/2]

= $60 + [ ($1,000 - $950) / 20) ] / [($1,000 + 950) / 2]

= [$60 – 2.50 / 975] x 100

= 6.45%

After Tax Cost of Bond = 6.45% x [1 – 0.34] = 4.26%

Cost of Preferred Stock

Cost of Preferred Stock = Annual Dividend / Selling Price

= [$2.50 / 25.00] x 100

= 10%

Cost of Common Stock

Cost of Common Stock = Rf + Bera[Rm – Rf]

= 3.50% + 1.20[13% - 3.50%]

= 14.90%

Weight of Bond = $100,00,000 / 2,00,00,000 = 0.50

Weight of Preferred Stock = $20,00,000 / 2,00,00,000 = 0.10

Weight of Common Stock = $80,00,000 / 2,00,00,000 = 0.40

Weighted Average Cost of Capital [WACC] = [After Tax Cost of Debt x Weight of Debt ] + [ Cost of Preferred stock x Weight of preferred stock ] + [ Cost of equity x Weight of common stock ]

= [4.26% x 0.50] + [10% x 0.10] + [14.90% x 0.40]

= 2.13% + 1% + 5.96 %

= 9.09%

Decision

The Weighted Average Cost of Capital [9.09%] is less than the required rate of return of 11.50%. So it’s better not to make warehouse investment. The warehouse investment shall not be acceptable