Question

RR Battery is a battery manufacturer producing high-quality lithium ion battery cells for electric cars. The business of RR has been flourishing in recent years and the board of directors intends to expand the business by acquiring companies overseas.
One of the acquisition targets is an electric car manufacturer in Taiwan. The management of RR believes this car manufacturer will bring handsome revenue to the company in the future.
As a business analyst of the RR, you have been asked to determine the Weighted Average Cost of Capital (WACC) of your company. The senior management of the company would like to use RR’s WACC to benchmark potential acquisition targets. The current capital structure information of the company is as follows:
i) 800,000 shares of common stock with a currently price of $50 per share
ii) 500,000 shares of preferred stock currently trading at $40 per share in the market.
The fixed annual dividend of this preferred stock is $4.80 per share.
iii) 30,000 units of 10-years, 7% p.a. coupon bonds with semi-annual interest payment.
The bond has exactly four years to maturity with a par value of $1,000. The current quotation of this bond is 95, which means 95% of its par value. Bonds with similar risk, interest term and maturity are currently selling at 8.50067% p.a. yield to maturity.
iv) An $11,500,000 long-term bullet payment loan with Open Bank. The loan was borrowed two months ago with a 9% p.a. borrowing rate. The market value of this bank loan is not available.
v) The expected market return is 12%, the risk-free rate is 4% and the beta of RR’s common stock is 1.25 respectively. The marginal tax rate is 20%.

Answer the following questions:
a) What is the capital structure of RR on a market value basis? Please make assumptions in your calculation if necessary.
b) Evaluate the weighted average cost of capital (WACC) of the company.
c) Discuss whether RR should simply apply its WACC as the benchmark to evaluate the acquisition of the electric car manufacturer.

Answer 1

a) Capital Structure based on market value is the relative proportion of common stock, preferred stock and debt in a company's total capital employed.

Market value of common stock = 800,000 shares x $50 per share = $40,000,000

Market value of preferred stock = 500,000 shares x $40 per share = $20,000,000

Market value of debt = 30,000 units x 95% of par value = $28,500,000

Book value of bullet payment loan = $11,500,000

Note: We will use book value here as market value is not avalable.

Sum of the market values of all components of capital = $40,000,000 +$20,000,000 + $28,500,000 + $11,500,000

= $100,000,000

% of common equity = $40,000,000 / $100,000,000 = 40%

% of preferred equity = $20,000,000 / $100,000,000 = 20%

% of debt = $28,500,000 / $100,000,000 = 28.5%

% of bullet payment loan = $11,500,000 / $100,000,000 = 11.5%

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b) WACC = Weight _C.Equity x R% _C.Equity + Weight _P.Equity x R% _P.Equity + Weight _Debt x R% _Debt x (1-Tax rate) + Weight _{Bullet loan} x R% _{Bullet loan}(1-Tax rate)

Weight _C.Equity = 40%, Weight _P.Equity = 20%, Weight _Debt = 28.5%, Weight _{Bullet loan} = 11.5%

R% _C.Equity = Rf + Beta (Rm - Rf) = 4% + 1.25 x (12% - 4%) = 14%

R% _P.Equity = Annual Dividend / Current market price = 4.80 / 40 = 12%

R% _Debt x (1-Tax rate) = 8.50% (1 - 20%) = 6.80%

R% _{Bullet loan}  x (1-Tax rate) = 9% (1 - 20%) = 7.20%

WACC = 40% x 14% + 20% x 12% + 28.5% x 6.80% + 11.50% x 7.20% = 10.77%

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c) Yes, RR should apply WACC as the benchmark to evaluate the acquisition of the electric car manufacturer. WACC is the average rate of cost of capital that is expected to all its security holders to finance its assets. So, using it as the discount rate is logical as it is the required rate of return to the capital providers of the company.

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