Question

(A) Please calculate the Weighted Average Cost of Capital (WACC) for the following company. Assumptions: Risk free rate = 4.0%; Company’s spread = 2.0%; Expected return of the market = 9.0%; Company Beta = 1.10; Company debt to capitalization ratio = 40%; and Company tax rate = 30%. (Please be sure to show your calculations.)

(B) Please define and explain the Hurdle Rate. (3 points)

Answer 1

a)

Cost of debt = (Risk free rate + credit spread) * (1-tax rate)

=(4 + 2)* (1-0.3)

= 6 * 0.7

= 4.2%

Debt to capitalisation ratio = 0.4

therefore weight of debt = 0.4

Weight of equity = 1- 0.4 = 0.6

Cost of equity according to CAPM = risk free rate + beta * ( Market return - risk free rate)

= 4 + 1.1 * ( 9 - 4)

= 4 + 5.5

= 9.5%

WACC= (weight of debt)*(cost of debt) + (weight of equity)* (cost of equity)

= 0.4 * 4.2 + 0.6 * 9.5

=1.68 + 5.7

=7.38 %

b)

Hurdle rate

The minimum rate of return that is required for a project is called a hurdle rate.

It serves as ameasure for accepting or rejecting a project. If the required rate of return is above the hurdle rate, then the project can be accepted and if it is lower than the hurdle rate then we should reject the project. Hurdle rate is directly proportional to the riskness associated with the project. If the project has more misk, then its hurdle rate will be high. Most companies use WACC as the default hurdle rate. Capital budgeting decisions also depend on the hurdle rate. The internal rate of raturn (IRR) can be compared to the hurdle rate since it is the break even rate i.e the rate at which the NPV of the project is zero