Question

2 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 $l shares, with a current market value cum-div of $l.17 per share. It has also issued $200,000 of 10 debentures, which are redeemable at par in five years' time and have a current market value of$105.30 cum-interest, and $lOO,OOO of $l irredeemable 6 preference shares, currently priced at $0.40 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 $60,000 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

For a company, cost of capital is the least rate of return that the company has to earn on its investments to meet investor expectations. For example, if a company can raise debt from banks at 15%, then 15% can be used as cut-off rate to break even.

The discount rate is the rate used to find the present value of future cash flows in DCF. The discount rate helps in finding if the future cash flows from a project will be worth more than the current capital invested. Thus a wrong discount rate would leave into wrong growth rate which the company would need to recover its investments and in turn impact the company’s financial planning in the long term.