Question

XYZ Ltd provides the following information about its capital structure:

60-day Bank Bill with a face value of $500,000. These bills are currently yielding 5% per annum. XYZ tends to use such bills on a revolving basis.

50,000 bonds with a face value of $100 each are selling at $96. The coupon rate for these bonds is 5%. These bonds pay coupon quarterly and have five more years to maturity.

5 million ordinary shares on issue. They were originally issued at $1, and today these shares are selling at $1.5 per share. XYZ is expected to pay a dividend of $0.20 in the next period. The past few years dividends have grown consistently at 2% per annum and this situation is expected to continue.

If the corporate tax rate is 30 per cent, then what is the company’s weighted average cost of capital?

Answer 1

There are three types of financial capitals in the company , bank bills, bonds and equity, i.e shares. The interest rate for the bank bill and bonds is 5%, as given. For calculating the cost of equity, we need to use the dividend growth model formula:

Price of stock = dividend in next period / (cost of equity - growth rate)

solving for cost of equity (e) = (dividend next period / price) + growth rate = 0.20/1.5 +0.02 = 15.33%

WACC = (weightage of bank bill * cost of bank bill + weightage of bonds * cost of bonds ) * (1-tax rate) + weightage of equity * cost of equity

wacc = (500k/10500k * 5% + 5000k/10500k * 5%) * (1-0.3) + 5000k/10500k * 15.33% = 9.13%

Note:

1. Since both bank bills and bonds involve interest payment which is tax deductible, we use after-tax rate in wacc.

2. since bank bills are used on a revolving basis, it implies that the company always has 500k of bank bills on its books. Hence, we consider the bank bills in wacc.