Question

Mary Francis has just returned to her office after attending preliminary discussions with investment bankers. Her last meeting regarding the intended capital structure of Apix went well, and she calls you into her office to discuss the next steps. "We will need to determine the required return for our intended project so that we have a decision criteria defined for the project," she says. "Do you have the information I need to describe capital structure and to calculate the weighted average cost of capital (WACC)?" you ask. "I do," she smiles. "We can determine the target WACC for Apix Printing Inc., given these assumptions," she says as she hands you a piece of paper that says the following: Weights of 40% debt and 60% common equity (no preferred equity) A 35% tax rate Cost of debt is 8% Beta of the company is 1.5 Risk-free rate is 2% Return on the market is 11% "Great," you say. "Thanks." "Be sure to indicate how these costs of capital might be used to determine the feasibility of the capital project," Mary says. "I want your recommendation about which is more appropriate to apply to project evaluation, too. Let me know what you think." "One more thing," she says as she stands up to signal the end of the meeting. "You did a good job with the explanations that you provided Luke the other day. Would you have time to define marginal cost of capital for me so I can include it in my discussions with investors? You seem to have a knack for making things accessible to nonfinancial folks." "No problem," you say. "I'm glad my explanations are so useful!" For this assignment, complete the following: Describe capital structure. Determine the WACC given the above assumptions. Indicate how these might be useful to determine the feasibility of the capital project. Recommend which is more appropriate to apply to project evaluation. Define marginal cost of capital. Please submit your assignment. For assistance with your assignment, please use your text, Web resources, and all course materials. Course Objectives: Assess the cost of capital and marginal cost of capital and their implications for capital budgeting. Compare and contrast alternative valuation methodologies and explain how a firm can maximize its value.

Answer 1

The capital structure in this case has more equity (60%) than debt (40%) and hence it can be said the business is being financed majorly through equity.

WACC = weight of equity*cost of equity + weight of debt*after tax cost of debt

Weight of equity = 60% or 0.6. Cost of equity will be computed using the CAPM model. As per this model cost of equity = risk free rate + beta*(return on market – risk free rate)

= 2% + 1.5*(11%-2%)

= 15.5%

After tax cost of debt = (1-35%)*8% = 5.20%

Thus WACC = 0.6*15.5% + 0.4*5.2%

= 11.38%

So WACC = 11.38%

WACC will be useful to determine the feasibility of the capital project as the cash flows of the project will be discounted to their present values using WACC. All the present values of the cash flows will then be added to determine NPV (net present value). If NPV is positive then the project is feasible otherwise it is not.

Marginal cost of capital is the weighted average cost of the last amount of new capital that has been raised by an organization for the purpose of capital investments. Marginal cost of capital is different from WACC as it does not consider the cost of equity and cost of debt that has already been issued. It just considers costs of new capital that are raised for financing new investments.

Out of WACC and marginal cost of capital it is the marginal cost of capital that should be used for project evaluation and capital budgeting purposes. This is because the return available on new projects should be compared with the costs of the new capital required to make the investments and not the cost of capital that has already been issued. Thus marginal cost of capital is a more suitable metric.