Question

INSTRUCTIONS: This question contains three (3) parts. Answer all parts of the questions. Clearly label your response to each part using bold text. For example: Part a): Your response...

(a) The weighted average cost of capital (WACC) can be calculated as

where E is the market value of equity, D is the market value of debt, V = E + D, k_e is the cost of equity, k_d is the cost of debt and t is the tax rate.

Briefly explain why k_e is not multiplied by (1 - t) in this WACC?

(b) Using a corporate tax rate of 30%, calculate Spyware’s after tax WACC based on the following information.

Spyware Ltd is financed through debt and equity. Currently, a Spyware share sells for $10.50 and 1 million of these shares have been issued. Analysis indicates that the appropriate Beta for a Spyware share is 1.25. Further, the risk-free rate is 5% p.a. and the expected market return is 13% p.a. Spyware has also issued 100,000 bonds. Each of these bonds has a face value of $100, three years to maturity, pay an annual coupon of 10% and currently trade for $105.154. Finally, Spyware has a bank loan with a balance of $2,000,000. The interest rate on this loan is 10% p.a.

(c) Outline one reason why the WACC from (b) may not be the appropriate WACC for evaluating all of Spyware’s capital investment decisions.

Answer 1

Part a) Ke is not multiplied by (1-tax) in calculating wacc because the dividend paid on equity is paid after tax , so there is no need to multiply it by (1-tax rate). Another reason is that the dividend on equity is not tax deductible like interest on debt.

Part b)

Total equity = 10.50 × 1,000,000 = $10,500,000

(+)Total debt = 100 × 100,000 = $10,000,000

(+)Total loan = 2,000,000

Total investment = $22,500,000

Weight of equity= 10,500,000/22,500,00 = 0.4667

Weight of debt = 10,000,000/22,500,000 = 0.4444

Weight of loan = 2,000,000 / 22,500,000 = 0.0889

Cost of equity = Risk free rate + beta (market return - risk free rate)

= 5% + 1.25 (13% - 5%)

= 5% + 1.25 (8%)

= 5% + 10%

= 15%

Using financial calculator to calculate the cost of debt

Inputs: N= 3

Pv= -105.154

Pmt= 10% × 100 = 10

Fv= 100

I/y= compute

We get, ytm of the bond as 8%

After tax cost= ytm (1-tax rate)

= 8% (1- 0.3)

= 8% (0.7)

= 5.6%

Cost of loan after tax= interest rate (1-tax rate)

= 10% (1-0.3)

= 10% (0.7)

= 7%

Wacc= weight of debt × after tax cost of debt + weight of loan × after tax cost of loan + weight of equity × cost of equity

= 0.4444 × 5.6% + 0.0889 × 7% + 0.4667 × 15%

= 2.49% + 0.62% + 7%

= 10.11%

Part C) Wacc from part B may not be appropriate for evaluating all the capital investment of spyware because the risk of all the investment may not be same as that of the firm. Due to which the wacc from part B if used can lead to rejection of good captital investment decision involving lesser risk than that of the firm.