Question

The capital structure of Orange Tradings (given in terms of both book value and market value) is

as follows

Bonds Preferred stock Common equityTotals

Book value $15,000,000 $2,000,000 $9,000,000$26,000,000

Market value $13,000,000 $2,500,000 $18,500,000$34,000,000

After-tax cost 7.0%
9.0%
14.0%

1. a) What is the weighted average cost of capital using both Book Value and Market Value calculations for Orange Tradings? (15Marks)

2. b) Orange Tradings is considering a project that costs N$320,000 where they would make a return of N$51,000. Would you advise the company to accept this project or not? Support your answer.

3. c) What is theoretically the best weighting method that Orange Trading should use? Why?

Answer 1

a) The WACC on the basis of Book value is :

weight of debt* after tax cost of debt +weight of preference capital 8 cost of preference capital weight of equity *cost + weight of equity *cost of equity

= $15,000,000/26,000,000*0.07 + 2,000,000/26,000,000*0.09 + 9,000,000/26,000,000*0.14

=0.0404 + 0.0069 + 0.0485

= 9.58%

Market value weights is:

= $13,000,000/$34,000,000 + 25,00,000/34,000,000 + 18,500,000/34,000,000

= 0.0268 + 0.0066 + 0.0762

= 10.96%

b) The rate of return on the project is :

$51,000/$3,20,000

=15.9375%

yes, we should accept this project as the rate of return on this project is more than the WACC. Taking on this project will add value to the company.

c) The book value is readily available in the valance sheet and the market value has to be ascertained by the analysts and this si only possible if the company is publicly listed and it is a difficult task to ascertain the market value but the market value is appropriate to use as investors would demand a required rate of return based on the market ale and not based on its book value.

In comparison to Book value, the market value is appropriate.

if we use the book value , we may not be able to maximise the shareholder wealth as we may end up accepting such projects which are supposed to be rejected.