Question

Mc Gordon Vision is a manufacturer of computer’s LCD screens in England, The Company is aiming to expand their business in Ireland by establishing a production plant in Ireland. This project will cost the company £100 million. The company has decided to establish a separate company for this project and to name it Irish Vision. Irish Vision plans to finance this project using 50% equity and 50% debt. Irish Vision reached a deal to issue a 5 year bond with annual coupon of 7.5 % of the face-value of the bond. T-bond annual rate 5.0%. Expected return on FTSE500 is 14% . The Variance of FTSE500 returns is 4. The covariance between Mc Gordon stock returns and FTSE500 returns is 5. Mc Gordon Vision has had no debt for the last 5 years. (i.e. Debt/Equity = 0). The tax rate is 40%. Calculate both Mc Gordon’s and Irish vision WACC

Answer 1

Calculatio of Beta :

Beta of security = (Covariance between Mc Gordon stock returns and FTSE500 returns) / Variance of FTSE500 returns

Where,

Covariance between Mc Gordon stock returns and FTSE500 returns = 5

Variance of FTSE500 returns = 4

Beta of security = 5 / 4 = 1.25

Calculation of Cost of eqiuty :

Cost of eqiuty = Risk free rate + Beta of security x (Market return - Risk free rate)

Where,

Risk free rate = T-bond annual rate = 5%

Beta of security = 1.25 (calculated above)

Market return = Expected return on FTSE500 = 14%

Cost of eqiuty = 5% + 1.25 x (14% - 5%)

Cost of eqiuty = 16.25%

Calculation of cost of debt :

Face value assumed to be Pound 100

Annual coupon of 7.5% = Pound 100 x 7.5% = Pound 7.5

Cost of debt = Pound 7.5 / Pound 100 = 7.5 (assuming bond will be redeemed at par at maturity)

Hence, before tax cost of debt = 7.5%

After tax cost of debt = 7.5% x (1 - tax)

After tax cost of debt = 7.5% x (1 - 0.4) = 4.5%

1. Mc Gordon’s WACC :

Since, Mc Gordon Vision has had no debt for the last 5 years, its WACC is equal to cost of equity = 16.25%

Hence, Mc Gordon’s WACC = 16.25%

2. Irish vision's WACC :

Given, capital structure of Irish vision consists of 50% debt and 50% eqity.

WACC = Weight of debt in capital structure x After tax cost of debt + Weight of equity in capital structure x Cost of eqiuty

WACC = 50% x 4.5% + 50% x 16.25% = 10.375%

Hence, Irish vision's WACC = 10.375%