Question

The management of Ethan plc is trying to decide on a cost of capital to apply to the evaluation of investment projects. The company has an issued share capital of 500,000 ordinary K1 shares, with a current market value cum-div of K1.17 per share. It has also issued K200,000 of 10% debentures, which are redeemable at par in five years’ time and have a current market value of K105.30 cum-interest, and K100,000 of K1 irredeemable 6% preference shares, currently priced at K0.40 per share ex-div. The preference dividend has just been paid, and the ordinary dividend and debenture interest are due to be paid in the near future.
Management considers the current capital structure of the company to be similar to their plans for its long-term capital structure.
The ordinary share dividend will be K60,000 this year, and the Directors have published their view that earnings and dividends will increase by 5% a year into the indefinite future. The company pays tax at 25% per year in the same year as profits.
Required:
a) Calculate the WACC.
b) Discuss the importance of the cost of capital in project appraisal and highlight the impact
that a wrong discount rate would have on decision making.

Answer 1

Face Value of 10% Debentures issued(Wd) = K200000

Cost of Capital for Debentures (Rd) = Interest rate*(1-tax rate) = 10(1-25%)= 7.5%

Face Value of K1 6% irredemable Preference Shares(Wp) = K100000

Cost of Capital of Preference shares(Rp) = 6%

FV of K1 Ordinary Equity shares(assuming FV =K1/share)(We) = K500000

Current Market Price of Share cum-dividend = K1.17

Current year Dividend per share(D0) = Total Div/No. of shares = K60000/500000= K0.12

Current Market Price of Share Ex-dividend(P0) = Price cum-div (-) Dividend = K1.17 - K0.12 = K1.05

P0 = D0(1+g)/(Re-g) [Re = Cost of Equity Capital ; g= growth rate of dividends= 5%]

K1.05 = K0.12(1+0.05)/(Re - 0.05)

Re = 17%

Total Capital (Wt) = Wd + Wp + We = K200000 + K100000 + K500000 = K800000

WACC = Rd * Wd/Wt + Rp * Wp/Wt + Re * We/Wt

= 7.5% * 200000/800000 + 6% * 100000/800000 + 17% * 500000/800000

= 13.25%

Cost of capital is important in the following ways:

• The cost of capital aids businesses and investors in evaluating all investment opportunities.
• The cost of capital can also aid in making key company budget calls that use company financial sources as capital.
• The cost of capital can be used to evaluate the progress of ongoing projects and investments by matching up the progress of those investments against the cost of capital.

Impact that a wrong discount rate would have on decision making:

The discount rate is the interest rate used to determine the present value of future cash flows in a discounted cash flow (DCF) analysis. This helps determine if the future cash flows from a project or investment will be worth more than the capital outlay needed to fund the project or investment in the present.

When the discount rate is large, there are larger differences between PV and FV (present and future value) for each cash flow than when the discount rate is small. Thus, when discount rates are large, cash flows further in the future affect NPV less than when the rates are small. Conversely, a low discount rate means that NPV is affected more by the cash flows that occur further in the future.

Therefore by taking a wrong discount rate the analysis of cashflows will be wrong and hence the Net present value computed will be in correct and hence the decision to accept or reject the project will be incorrect.