Question

How can we use the weighted average cost of capital in investment appraisal? Explain this using your OWN example / scenario.

Answer 1

All the companies aspire to grow and sustain their growth. In order to fuel and sustain their growth strategies they need capital. This capital is required either to grow & expand or to run the day to day operations. Accordingly a firm requires long term capital as well as short term or working capital. We have seen various financial instruments in last section. A company ultimately resort to those financial instruments to raise capital. Nothing comes free of cost. Since capital is resource it will have a cost associated with it. This section aims at explaining costs of various components of capital and the overall cost of capital.

In investment appraisals, WACC reflects the average risk of projects that make up the firm. There are many ways WACC is applied to capital project appraisals:

• The rate of return that the suppliers of capital, bondholders and owners, require as a compensation for their contribution of capital
• The cost to finance assets of the firm
• The minimum rate which the assets of the firm must earn to add to shareholders wealth
• The rate of return that must be earned on additional investment if firm value is to remain
• unchanged
• The opportunity cost which is used as a benchmark to evaluate capital projects

A capital investment decision is undertaken if it generates return in excess of WACC. A project generating a return less than the rate at which capital has been created for it is actually eroding shareholders value. Assume a situation where you borrow money at 15% to generate a return of 10% on it. At the end of a year even though you may be profitable, you are actually eroding the capital. Hence, internal rate of return of a capital investment is calculated and compared with WACC. A capital investment should typically be undertaken only if rate of return of such investment exceeds WACC, the rate at which capital has been created.

For the purpose of this section, we will assume a firm’s capital structure primarily comprises of three components:

Sl.	Component	Cost	Weights
1.	Debt (Loan, Debenture or Bonds)	Kd	Wd
2.	Preferred Stock (Preference shares)	Kps	Wps
3.	Equity Stock (Common shares)	Ke	We

So, for a typical firm with marginal tax rate as “T”,

Example:

Sundaram Retail has a capital structure which consists of 60% long-term debt and 40% common stock. Sonali Sundaram, the company’s CFO has obtained the following information:

• The before-tax yield to maturity on the company’s bonds is 12%.
• The company’s common stock is expected to pay a Rs. 10 dividend at year end and it is expected to grow at a constant rate of 7% a year. The common stock currently sells for Rs. 90 / share.

Assume the firm will be able to use retained earnings to fund the equity portion of its capital budget. The company’s tax rate is 30%. What is the company’s weighted average cost of capital (WACC)?

Solution:

Cost of equity = D₁ / P₀ + g = 10 x (1 + 7%) / 90 + 7% = 18.89%

WACC = W_d x K_d x (1 – T) + W_e x K_e = 60% x 12% x (1 – 30%) + 40 x 18.89% = 12.60%.