03 May finance
Example Re Team week 4 Assig
| Scenario: You have been asked by management of Acme Co. to calculate its weighted average cost of capital, to use in evaluating a new company investment. The firm is considering a new investment which it believes will generate an internal rate of return of 13.0%. The market value of Acme’s capital structure is as follows: | ||||||
| Source of Capital | Market Value | Weights | ||||
| Bonds | $35,000,000 | 35.0% | ||||
| Preferred Stock | $15,000,000 | 15.0% | ||||
| Common Stock | $50,000,000 | 50.0% | ||||
| Total | $100,000,000 | 100.0% | ||||
| To finance the investment, Acme has issued 25 year bonds with a $1,000 par value, 4% coupon rate and at a market price of $850. Preferred stock paying a $1.50 annual dividend was sold for $30 per share. Common stock of Acme is currently selling for $60 per share and has a Beta of 1.4. The firm’s tax rate is 32%. The expected market return of the S&P 500 is 14% and the 10-Year Treasury note is currently yielding 2.5%. | ||||||
| Determine what discount rate (WACC) should use to evaluate the project. | ||||||
| Assess whether Acme should make the investment. | ||||||
| Calculating The Weighted Average Cost of Capital (WACC) | ||||||
| Capital Structure (Weights) | Before-Tax Cost | Tax Rate | After Tax Cost* | Weighted After-Tax Cost** | ||
| Bonds | 35.0% | 5.1% | 32.0% | 3.4% | 1.21% | |
| Preferred Stock | 15.0% | 5.0% | 5.0% | 0.75% | 0.0% | 0.00% |
| Common Stock | 50.0% | 18.6% | 18.6% | 9.30% | ||
| Total | 100.0% | 11.26% | WACC | |||
| *For debt use (1-Tax Rate) x Before-tax cost | ||||||
| **Cap structure weight x After-tax cost. Sum all to get WACC | ||||||
| The WACC for Acme is 11.26% and the expected return on the new investment is 13%, therefore Acme should make the investment. | ||||||
| Calculate cost of common equity | ||||||
| Using Capital Asset Pricing Model to calculate the cost of common equity: | ||||||
| CAPM formula: | Ke = Rf + b(Rm – Rf) | |||||
| Given | ||||||
| Rf | 2.5% | |||||
| Rm | 14.0% | |||||
| beta | 1.4 | |||||
| (Rm – Rf) | 11.5% | This is known as the market risk premium. | ||||
| b(Rm – Rf) | 0.161 | |||||
| Ke = Rf + b(Rm – Rf) = | 18.6% | This is the cost of common equity. | ||||
| Calculate cost of debt | ||||||
| Calculate the before tax cost of debt (or use amount given if appropriate). | ||||||
| Using Excel to calculate the annualized rate or yield on the bonds: | ||||||
| Semiannual values | ||||||
| Par value | $ 1,000 | |||||
| cupon rate | 4.0% | |||||
| payment | $ 40.00 | $ 20.00 | ||||
| years to maturity | 25 | 50 | ||||
| PV | Par (FV) | pmt | nper | Smiannual Rate | Annual Rate | |
| $ 850.00 | $ 1,000 | $ 20.00 | 50 | 2.5% | 5.1% | |
| Calculate cost of preferred equity | ||||||
| Calculating the cost of preferred stock by dividing the dividend by the price: | ||||||
| Per Share price | $ 30.00 | |||||
| Dividend | $ 1.50 | |||||
| Cost of preferred stock | 5.0% |
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