The discount rate (WACC) vestor should use to evaluate the warehousing facility project
In order to determine the Weighted Average Cost of Capital Vestor should use in evaluating the project, the percentage of each capital component relative to the total capital shall be calculated. After this, the interest on the bond shall be used to compute the effective interest rate taking to account the tax rate. Then, the WACC for each capital component shall be calculated by multiplying the cost of the capital by its respective weight or percentage established in the first procedure, before adding all the WACCs of each capital component (Kodukula & Papudesu, 2006, p. 46).
Percentage of each capital component (Kodukula & Papudesu, 2006, p. 42);
Bonds = $10,000,000/$20,000,000 = 0.5
Preferred Stock = $2,000,000/$20,000,000 = 0.1
Common Stock = $8,000,000/$20,000,000 = 0.4
Given the 6% interest rate on the bond, the effective interest rate taking to account the tax rate 34% is:
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0.06 * (1-0.34) = 0.0396
The weighted cost of capital for each capital component by multiplying the weight of each capital component by the coupon rate:
Bonds 0.06 * 0.5 = 0.03
Preferred Stock 0.06 * 0.1 = 0.006
Common Stock 0.06 * 0.4 = 0.024
Summation of all the costs of capital to obtain the WACC:
0.03+0.006+0.024 = 0.06
WACC = 0.06
Whether Vestor Should Make the Warehouse Investment
In the course of analyzing the feasibility of the investment, it is important to consider the following factors: the underlying costs of the project, the potential benefits of the project and the net present value (NPV), the compatibility of the project with corporate strategy and the available real options and among other factors.
First taking to account the underlying costs of the project, from the prevailing circumstances, it is important to strike a balance between the private risks and the market risks involved (Kodukula & Papudesu, 2006, p. 42). This is attributed to the fact that an investment is affirmatively feasible if a viable risk is taken, taking to account the source of capital. This is also in tandem with the investment fiction that investors are more inclined to risk paying premium for risks that are market-driven in nature, compared to private risks. From the prevailing circumstances, it is certainly the fact that a greater percentage of the capital component (50%) comes from the company’s bonds, followed by 40% for the commons stock and 10% percent on preferred stock. It would suffice to say that the risk in this situation is viable as it is private in nature.
First vesting a greater percentage of the capital component in the common stock reduces the risk of loss in case the investment deteriorates. This is because the dividends attributed to the common stock are fewer compared to the preferred stock, which has been allocated the lower percentage of the capital component. To this extent, it would suffice to say that Vestor should make the warehouse investment as it is feasible taking to account the allocation of the underlying costs of the project.
Second, it would be important to consider the potential benefits that the project is envisaged to generate, in relation to the costs incurred in setting up the project. In this regard, it is important to take to account various factors such as the projects net present value in relation to the discount rate for the cash flow, which is premised on the weighted average cost of capital (Kodukula & Papudesu, 2006, p. 39). The calculated WACC of 0.06 represents a projection of a viable discount rate. Taking to account the 34% tax rate, the 6% coupon rate and the fact that a greater part of the capital for the investment comes from the companies binds, it would suffice to say that the investment is viable and prone to make profitable returns.
Further, it is also important to consider the investments compatibility with the company’s corporate strategy. Being a software development company, at the face of it, it would suffice to say that a warehousing investment is incompatible with the company’s corporate strategy. This is attributed to the fact that software development is so remote from warehouse operation and management and therefore operation of the warehouse might not be a viable investment for the warehouse development company.
Finally, it is also important to consider the available real options such as option to defer, growth option, option to abandon or option to switch among other options. Since it has been assessed above that the warehouse investment is incompatible with software development, real options such as to abandon and differ will be inevitable. However, if the two were compatible, options to growth or switch would be available. To the extent that the investment projects such weaker real options, it would suffice to say the investment fails the feasibility test.
References
Kodukula, P., & Papudesu, C. (2006). Project valuation using real options: a practitioner's guide. Miami, FL: J. Ross Publishing.
