Question

“BLACKFRIDAY” company is planning an expansion of its existing production capacity. The firm hired you as a consultant for the expansion project. Since you are a savvy project manager, you first decided to estimate the firm’s cost of capital based on the available data.

Data:

• Tax Rate: 40%
• Bond: Coupon rate 12%, Maturity Years 15, Present value $1150
• Preferred Stock: Dividend rate 10%, Par Value $100, Present Value $111 Common Stock: Market price $50, D₀=$4.20, Dividend growth 5%, Beta 1.2, Treasury Bond yield 7%, Market risk premium 6%. When the firm uses Bond-yield+Premium method, the risk premium is 4%.
• Capital structure of ABC is as follows;
  • Debt 30%, Common Equity 60%, Preferred Stock 10%

Next, you asked your assistant “Mr.COUPON” to give his opinion on the following burning questions;

1. What sources of capital you should consider for WACC? Should the sources be before tax? Should the costs be historical?
2. What is the BLACKFRIDAY’s Cost of Bond? What is the after-tax Cost of Bond to be used in WACC?
3. What is the cost of the firm’s preferred stock?
4. Calculate Cost of Equity of using CAPM and Bond-yield+Premium method, and DCF methods.
5. What is your final Cost of Equity?
6. Do you agree that the cost of new equity is cheaper than the cost of retained earnings? Why?
7. What is flotation cost and how do you adjust it?
8. If the flotation cost of new stock issue is 10%, what is the estimated cost of equity considering the 10% flotation cost under DCF method you calculated in question iv above?
9. What are the components of the WACC you calculated above to be blamed for higher WACC? What can be done to reduce the WACC further?
10. Should you use this WACC for all the projects? Why and why not?

Answer 1

Blackfriday
Sr. No.	Particulars
i.	For calculating WACC (Weighted Average Cost of Capital) - all sources of finance shall be considered i.e. Bond, Preferred Stock and Common stock as well. Costs of capitals to be considered shall be post tax and shall not be based on historical data since project evaluation is carried out for a project to be undertaken in the future.
ii.	Cost of bond of the company is as follows: a) Pre tax cost of bond - 12% b) Post tax cost of bond - 12% - 40% = 7.20%
iii.	Cost of the firm's common stock: a) Based on historical data - 10% b) based on current market price - 100*10%/111 = 9.009% (This shall be used to evaluate future projects)
iv.	Cost of equity using CAPM model: 1. Risk Free rate of return + beta ( market risk Premium) i.e. 7% + 1.20 (6%) = 14.20% 2. Bond Yield + Premium i.e. 7% + 4% = 11.00% 3. DCF method: As per DCF method: P0 (Price in year 0) = D1 (Dividend in year 1 ) / {Cost of equity i.e. (Ke) - growth rate (g)} substituting the values in the formula: 50 = (4.20*1.05)/(Ke - 0.05) Ke-0.05 = 5.25/50 Ke = 0.155 Therefore, cost of equity using discounted cashflow technique is 15.50%