Accounting and Finance Weighted Average Cost of Capital

Question: Discuss about theAccounting and Financefor Weighted Average Cost of Capital. Answer: Introduction For estimation of the given project, it is imperative that analysis through capital budgeting techniques be performed. However, to enable the same, the cost of capital or WACC computation plays a critical role. This is also applicable for the evaluation of the purchase of the new conveyer belt that Melbourne manufacturing company limited is seeking to conduct. The main aim of this report is to carry out the computation of WACC based on the information provided on the company and also opine of usage of the company WACC as the suitable discount rate for the project so that an accurate recommendation could be offered in relation to carrying on with the new project or not. Computation of WACC In order to estimate WACC or Weighted Average Cost of Capital, it is imperative to compute the cost of the various means of financing used i.e. corporate bonds, preference shares and ordinary shares. Cost of Corporate Bonds Semi-annual coupon rate applicable on the bonds = 5.6% pa or 2.8% per half year In the given case, it is assumed that the face value is equal to market value and hence the cost of bonds would be the effective annual coupon rate applicable on the bonds. Effective Annual Rate = (1+(2.8/100))2 1= 5.68% Assuming that the applicable tax rate for the company is 30%, the after tax cost of debt is computed as follows (Damodaran, 2008). After tax cost of debt = 5.68*(1-0.3) = 3.976% pa Cost of Preference Shares Market price of unit preference share (P)=$ 10 Annual dividend paid per preference share (D) = $1.35 Hence, cost of preference share = (D/P)*100 = (1.35/10)*100 = 13.5% pa Cost of Ordinary Shares For estimation of the cost of equity, the appropriate model would be the CAPM approach which advocates the following relation (Parrino Kidwell, 2011). Cost of Equity = Risk Free Rate + Beta * Market Risk Premium Applicable yield on 10 year government bond is taken as the benchmark for the risk free rate which currently stands at 2.26% pa Also, Market Risk Premium (Given) = 9.7% pa Beta of the company = 1.3 Hence, cost of equity = 2.26 + 1.3*9.7 = 14.87% pa Estimation of respective weights of the various financing sources Market value of corporate bonds = $ 1.3 million Market value of preference shares = 10*500,000 = $ 5 million For the market price estimation of an ordinary share, the Gordon Dividend Discount Model needs to be applied (Graham Smart, 2012). Dividend expected the next year or t=1 is $ 0.72 Dividend expected (t=2) = 0.72*1.08 = $ 0.7776 Dividend expected (t=3) = 0.7776*1.08 = $0.8398 Dividend expected (t=4) = 0.8398*1.08 = $ 0.907 Dividend expected (t=5) = 0.907 * 1.03 = $ 0.934 It is expected that from fifth year onwards the growth in dividend would be constant at 3% pa till perpetuity. Hence, intrinsic price of the share = (0.72/1.1487) + (0.7776/1.14872) + (0.8398/1.14873) + (0.907/1.14874) + 0.934/((0.1487-0.03)(1.14875)) = $ 6.23 Number of outstanding shares = 1.4 million Hence, market value of shares = 1.4 *6.23 = $ 8.7 million Hence, total capital = 1.3 + 5 + 8.7 = $ 15 million Weight of debt = (1.3/15) = 0.087 Weight of preference shares = (5/15) = 0.3333 Weight of ordinary shares = (8.7/15) = 0.58 Therefore WACC = 3.976 * 0.087 + 13.5*0.3333 + 14.87*0.58 = 13.47% pa Application of WACC It is imperative to note that the above computed value is the companys WACC which could be used as the discount rate for the given project only if the following conditions are fulfilled (Petty et. al., 2015). The underlying risk associated with the project is comparable to the underlying risk associated with the average project of the firm. In the event of risk being higher or lower, suitable modifications would be required to adjust WACC to a higher or lower value respectively. Further, the incremental funding pattern of the project is similar to the existing capital structure for the firm. In case, the underlying contribution of the various finance sources is varied, it is imperative that suitable modifications would be required to be made. Conclusion From the above discussion, it is apparent that the WACC for the company is 13.47% pa and the application of WACC on the conveyer belt project would depend on the underlying risk level of the project and the funding pattern. References Damodaran, A 2008, Corporate Finance, 2nd eds., Wiley Publications, London Graham, J Smart, S 2012, Introduction to corporate finance, 5th eds., South-Western Cengage Learning, Sydney Parrino, R Kidwell, D 2011, Fundamentals of Corporate Finance, 3rd eds., Wiley Publications, London Petty, JW, Titman, S, Keown, AJ, Martin, P, Martin JD Burrow, M 2015, Financial Management: Principles and Applications, 6th eds., Pearson Australia, Sydney