weighted average cost of capital (WACC).

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Overview of Project:weighted average cost of capital

The desired Debt to Equity ratio is 1.

Debt financing is from 3 sources, overdrafts, bank bills and debentures with the ratio of overdraft to bank bills to dentures are 1:2:3 respectively.

Debentures:

-12% coupons per annum

-face value is $1000.

-time until maturity is 6 years.

-current price of debenture is $8022.23

To calculate the effective required rate of return.

After tax cost of interest = r (1-c)

Where; c = the corporation tax rate, r = the yield to maturity (YTM)/redemption yield.

Using trial and error we solve the following equation.

  • $8022.23 = $12*(1+r) ^-1 + $12*(1+r)^-2 + …+ $1012*(1+r)^-6

Initially, try 15% as r,

$12*3.7844[15%, six-year annuity] + $1000* 0.86957[pv. 15%, six-year]

= $45.4137+ $869.565

$914.97892

Try 14% as r.

$12*3.8887[14%, six-year annuity] + $1000*0.8772[pv. 14%, six-year]

= $46.6640 + $877.193

$923.8568

Yield ~ 14% + [923.85-922.23/923.85-914.97]*1 =14.1824

14.1824(1-0.30) = 9.9277.

= 9.9277%.

Bank bills;

Face value = $100000, current price = $97593.59

  • $100000 = $97593.59* (1+i) ^90/365.
  • (1.0247)^365/90 = (1+i)
  • I = 10.40%

And it is specified that the bank overdraft rate is 1% per annum above the bank bills rate.

  • 40 + 1 = 11. 40.
  • 40%

Return on equity capital.

-Selling price for a share is $8.00

-Projected dividends for year one is $1.10

-Dividends are expected to grow at 6% per annum indefinitely.

i = d (1 + g) /v + g

Where v= current market value per share, d = dividend per share, I = discount rate and g = growth rate of dividends.

The total expected return of investing in a share is the dividend yield plus the growth in dividends.

  • $1.10*(1 + 0.06)/8 + 0.06
  • ($1.10*1.06)/8 + 0.06
  • 20575 ~ 20.575%

WACC= E/V*Re + D/V* Rd*(1-t)

Re=cost of equity, Rd = cost of debt, E = Market value of the firm’s equity, D= Market value of the firms debt, V = E + D, E/V =% of financing that is of equity, D/V = % of financing that is of debt.

  • We know that the Debt/Equity ratio is desired to be 1, say 50% debt and 50% equity and the overdraft/bank bills/ debenture ratio is 1:2:3
  • 40%*10 + 10.40%*20 +9.9277%*30 = 6.198
  • 57%*50 = 10.198
  • Our V=100; 50+50.
  • WACC = 10.198/100+ 6.198/100
  • 10198 + 0.06198 =0. 16396 ~ 16. 396

= 16.4%

Based on the WACC of the project at 16.4%, the project is viable.

WBC can draw more important inferences from WACC to help understand various important issues that the management of the company should address. Therefore, it is important that WBC calculates WACC as it acts as a measure of value of the company.

It is important for any company to make investment decisions and evaluate projects with similar or dissimilar risks. Calculation of Net Present Value and Economic added value requires WACC. WACC analysis can be looked at from two angles, the investors and the companies (Lumby, 1994). From the company’s angle; it is seen as the blended cost of capital which the company has to pay for using for both debt holders and owners. It also serves to acts as a benchmark rate to decide on accepting or rejecting a project if the project is of similar risk with existing projects. Moreover, even if a project faces a different set of risks, WACC can be used with certain modifications, e.g. The risk adjusted WACC. It’s important also for WBC to find out the WACC because from their investors angle it is seen as the opportunity cost of their capital.

The assumptions that come with using WACC for project evaluation are;

  1. All the projects undertaken by the company are of same risk profile.
  2. The source and mix of financing the new projects is same as the current capital mix of the company.

The main limitation for this method in project appraisal is that it assumes same rate can be used for projects which will forestall all the individual projects. Also it does not take into consideration the floatation cost of raising the marginal capital for new projects. It’s also based on an impractical assumption of same capital mix which is always difficult to maintain.

In conclusion WACC is an important metric used for various purposed but it has to be used very carefully (Pike & Wolfe, 1994). The weights of the capital components should be expressed in market value terms. These market values should be determined carefully and accurately because faulty calculations will result to faulty investment decisions.