Question

A listed industrial company is considering a major investment. The company’s investment projects team needs an appropriate rate at which to discount the estimated after-tax cash flows for the investment. Following the company’s normal practice this is based on the Weighted Average Cost of Capital.

Statement of financial position/long-term financing information:

	$m
160 m. ordinary shares of $0.5 each	80
Share premium account	27
Revaluation reserve	26
Retained earnings	9
7.2% loan	67

The loan interest for the current year has just been paid. Interest is payable at the end of each of the next 3 years and the loan is to be redeemed, in cash, at a 5% premium at the end of the three years.

A dividend of 18c per share has just been paid. Dividends have shown an average annual growth rate of 7% over recent years.

The current share price is 210c and the loan has a market value of $97 (per $100 nominal).

The corporation tax rate is expected to be 30% for the near future.

Required:

1. Calculate the company’s Weighted Average Cost of Capital (WACC).

Explain your workings and any assumptions.

Justify the basis of the weightings which you used.

2. Explain any criticisms which could be made of using the figure calculated above as the discount rate for assessing the investment.

Answer 1

A) Calculation of weighted average of capital

Cost of equity

Share information
Current market price (cent)	210
Dividend paid	18
Terminal growth	7%

As per dividend discount model: Market price = [Dividend paid*(1+g)]/(Ke-g)

210 = 18*1.07/(Ke-0.07)

Ke-0.07 = 0.0917

Ke = 16.1714%, where Ke is the cost of equity

Market cap of the company = Number of shares*market price = 160*210/100 = USD 336 million

Cost of debt

Market value of debt	97
Annual interest	7.2
Premium on re-payment	5%
Repayable value	105

YTM on debt can be calculated as follows:

[C+{(F-P)/t}]/[(F+P)/2] or [7.2+{(105-97)/2}]/[(105+97)/2] = 11.0891%

Average tax rate 30%

Post tax cost of debt = 11.0891%*(1-30%) = 7.7624%

Market value of debt per 100 FV = 97

Book value of debt (in million) = 67

Market value of debt = 67*97/100 = USD 64.99 million

Source of funding	Market value USD million	Wt	Cost	Wt*cost
Equity (Market capitalization)	336.00	83.8%	16.1714%	13.5505%
Debt (Market value)	64.99	16.2%	11.0891%	1.7973%
	400.99			15.3477%

Therefore, the weighted average cost of capital is 15.3477%

For the above we have used market values to calculate both the cost of capital and the weights. The reason is, this reflects the current cost of capital of the company and is the cost that the company will pay if they raise capital at present time.

B) WACC may not be suitable to be used in the project because

1. The risk profile of the project can be different from the overall risk profile of the company. As a result, the discount rate will be different

2. The means of financing can be different, that is the company might use a different debt to equity ratio compared to the debt to equity ratio based on the current market value

3. Cost of financing the new project can be different from the both, the book cost of capital and the current market cost of capital. This will result in skewed NPV for the project.