Question

Geralt Technologies is considering a major expansion program that has been proposed by the company’s information technology group. Before proceeding with the expansion, the company need to develop an estimate of its cost of capital. Assume that you are an assistant to Henry Cavill, the financial vice-president. Your first task is to estimate Geralt’s cost of capital. Henry has provided you with the following data, which he believes may be relevant to your task:

(i) The firm’s tax rate is 40%.

(ii) The current market price of Geralt’s $1,000 par value, 12 percent coupon, semi-annual payment, non-callable bonds with 15 years remaining to maturity is $1,153.72. Geralt does not use short-term interest-bearing debt on a permanent basis.

(iii) The current price of the firm’s 10%, $100 par value, annual dividend, perpetual preferred stock is $111.10. The company would incur a issuing cost of 6%.

(iv) Geralt’s common stock is currently selling at $50 per share. Its last dividend was $4.19, and dividends are expected to grow at a constant rate of 5% in the foreseeable future. Geralt’s beta is 1.2, the yield on T-bonds is 7%, and the market risk premium is estimated to be 6%. For the bond-yield-plus-risk-premium approach, the firm uses a 4% point risk premium.

(v) Geralt’s target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity.

To structure the task somewhat, Henry has asked you to answer the following questions ( Without using financial Calculator ):

1 (a) What is Geralt’s overall, or weighted average, cost of capital (WACC). Use the cost of retained earnings as cost of common equity.

(b) Geralt is interested in establishing a new division, which will focus primarily on developing new Internet-based projects. In trying to determine the cost of capital for this new division, you discover that stand-alone firms involved in similar projects have on average the following characteristics:

• Their capital structure is 40% debt and 60% common equity.

• Their cost of debt is typically 12%.

• The beta is 1.7.

Given this information, what would your estimate be for the division’s cost of capital? Note that Geralt uses the CAPM to calculate the division’s cost of capital.

Answer 1

a.

Weighted Average Cost of Capital is the rate of return which an investor uses to assess the company's profitability and return generating capabilities.

WACC = Wd (post tax cost of debt) + We (Cost of Equity) + Wp (Cost of Preferred Stock)

Post tax cost of debt = 12*(0.6)

= 7.2 %

Cost of Preferred Stock = Preference Dividend / Market Price of Preference Capital

Market Price of Preference Capital = Cost + Cost of Issue

= 100 + 6% = $ 106

Cost of Preferred Stock = 10 / 106 = 9.43%

Cost of Eqiuty shall be calculated using DDM.

Cost of Retained Earnings = (Upcoming year's dividend / stock price) + growth

Cr = [(4.19(1.05))/50] + 0.05

= 13.8%

WACC

Particulars	rate	Weights	Weighted Return
Equity	13.80	0.60	8.28
Preference Stock	9.43	0.10	0.94
Debt	7.20	0.30	2.16
WACC			11.38 %

b.

WACC = Wd (post tax cost of debt) + We (Cost of Equity)

Post tax cost of debt = 12*(0.6) = 7.2 %

Cost of Eqiuty shall be calculated using CAPM.

Ex = Risk Free rate + Beta ( Market Premium)

= 7 + 1.7(4)

= 13.8 %

Particulars	rate	Weights	Weighted Return
Equity	13.80	0.60	8.28
Debt	7.20	0.40	2.88
WACC			11.16 %