Question

Assume that you have been hired as a consultant by Whole Foods to estimate the firm's weighted average cost of capital. You have the following information:

• Common stock currently sells for $9.00 per share, the company expects to earn $1.80 per share during the current year, its expected payout ratio is 75%, and its expected constant growth rate is 7.00%. The stock has a beta of 1.3. The balance sheet shows that the company has 12 million shares of stock, and the stock has a book value per share of $5.00.

• Balance sheet shows a total of $22 million long-term debt with a coupon rate of 8.40%. Bonds have 14 years to maturity and a quoted price of 106.4. The bonds pay interest semiannually.

• The expected market return is 9% and the risk-free rate is 2%.

• The company recently decided that its target capital structure should have 40% debt,

  with the balance being common equity. The tax rate is 40%

1) Calculate the company’s WACCs based on book, market, and target capital structures. Which one would you use to evaluate a project?

2) You are evaluating a project that has a risk factor of 3%. What is the minimum expected return you would require from such a project in order to accept it?

Answer 1

Solution (1)	Company’s WACCs based on book, market, and target capital structures.
	(a) based on book value ( refer workings also)
		Book value	cost after-tax adjustment	weight	Weighted average cost
	Common stock ( 12 Million stocks@ $ 5)	60000000	11.10	0.73	8.12
	Long term debts	22000000	5.04	0.27	1.35
	Total	82000000			9.47
	Hence, WACC=9.47%
	(b) based on market value ( refer workings also)
		Market price	cost after-tax adjustment	weight	Weighted average cost
	Common stock ( 12 Million stocks	108000000	22.00	0.82	18.08
	Long term debts	23408000	4.75	0.18	0.85
	Total	131408000			18.93
	Hence, WACC= 18.93%
	(c) based on target capital structure (book value base) ( refer workings also)
		Target capital structure	cost after-tax adjustment	weight	Weighted average cost
	Common stock ( 12 Million stocks	49200000	11.10	0.60	6.66
	Long term debts	32800000	5.04	0.40	2.02
	Total	82000000			8.68
	Hence, WACC= 8.68%
	(d) Which one would you use to evaluate a project?
	Since WACC based on market value is more realistic which is based on the current value, we would use WACC based on market value.
	Working-1
		Market price	Book value
	Current capital structure
	Common stock ( 12 Million stocks	108000000	60000000
	Long term debts	23408000	22000000
	Total	131408000	82000000
		Target capital structure
	Common stock ( 12 Million stocks	49200000
	Long term debts	32800000
	Total	82000000
	Working-2
	As per dividend discount model
	Cost of Equity = (Expected dividend/Price)*100+growth
	Where,
	Cost of equity(Ke) = ?
	Expected dividend (d1) = 1.8*75% = 1.35
	Growth rate (g) =7%
	Price(p)= $ 9
	Hence,
	Ke = (1.35/9)*100+7% = 22%
	Working -3
	As per CAPM
	Ke = Risk free rate + Risk premium*beta
	= 2% +(9-2)*1.3
	=11.1%
	Working-4
	Bond yield to maturity
	= coupon amount + (Face value-purchase price)/period
	(Face value+purchase price)/2
	= 1848000+(22000000-23408000)/28
	(22000000+23408000)/2
	=1797714/22704000 = 0.0792 or 7.92%
	After tax = 7.92(1-0.4)   = 4.75%
	working-5
	cost of bond after tax =8.4*(1-0.4) = 5.04%
Solution (2)	minimum expected return , where risk factor of 3%.
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