Weighted Average Cost of Capital (WACC) is a crucial tool for calculating the rate of return an organization or a firm expects to compensate its investors. WACC mainly includes weights of fractions of each financing source in the firm’s capital structure, and they include bonds, common stock, preferred stock, and any other long-term debt ( Brotherson, Eades, Harris, & Higgins, 2015 ). The paper will complete the scenario below using the WACC project.
“ Scenario: You work for an investment banking firm and have been asked by management of Vestor Corporation (not real), a software development company, to calculate its weighted average cost of capital, to use in evaluating a new company investment. The firm is considering a new venture in a warehousing facility, which it believes will generate an internal rate of return of 11.5%. The market value of Vestor's capital structure is as follows:
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|
Source of Capital |
Market Value |
|
Bonds |
$10,000,000 |
|
Preferred Stock |
$2,000,000 |
|
Common Stock |
$8,000,000 |
To finance the investment, Vestor has issued 20-year bonds with a $1,000 par value, 6% coupon rate and at a market price of $950. Preferred stock paying a $2.50 annual dividend was sold for $25 per share. The common stock of Vestor is currently trading for $50 per share and has a Beta of 1.2. The firm's tax rate is 34%. The expected market return of the S&P 500 is 13%, and the 10-Year Treasury note is currently yielding 3.5%.
Determine what discount rate (WACC) Vestor should use to evaluate the warehousing facility project.
Assess whether Vestor should make the warehouse investment.
Prepare your analysis in a minimum of 700 words in Microsoft Word.
Use Microsoft Word tables in the presentation. Show all calculations and analysis in the presentation.
Format your assignment consistent with APA guidelines.”
Calculations
Cost of Bonds
950= (60* (1- (1+r) ^-20)/ r) + (1000/ (1+r) ^20
Solving the equation
r= 6.45%
After-tax cost = (1-0.34) *0.0645
The cost of the bond will be
4.26%
Cost of Preferred stock
= Dividend/Market Price
= 2.5/25
= 10.00%
Cost of Common Stock
Cost of Equity = Risk- Free rate + Beta* (Market Interest Rate-Risk-Free Rate)
= 0.035+(1.2*(0.13-0.035))
= 14.90%
Calculation of WACC
WACC = Kd×(1-t) ×wd+ kp×wp+ ke×We
WACC= 6.45× (1-.35) ×1000000/2000000 +10×200000/2000000+14.9×800000/2000000
WACC=9.10%
Because the investment will generate a higher Internal Rate of Return of 11.5% which is more that the WACC of 9.10% Vestor should then go on with the warehouse investment.
Vestor Investment advice
As an investment organization the main aim was to assess whether or not Vestor should invest in the warehouse facility which would generate an internal rate of return of about 11.5%. To determine if the investment was viable the first step was to find out whether the IRR is more significant than WACC. The main argument behind that idea is that when the IRR is higher than the WACC the there is an increase in cash flow which in return increases shareholders equity and therefore the investment should be made ( Brotherson et al., 2015 ).
Looking at the calculation performed the IRR is 11.5% which is higher than the WACC of 9.10%. This means that Vestor should go on with the warehouse investment. Because organisations have limited capital and resources to investment and multiple projects to commit the available capital on it is essential they rank the projects ( Krüger, Landier, & Thesmar, 2015 ). The projects which have the highest internal rate of return should be given the priority.
Assess whether Vestor should make the warehouse investment
WACC can be described as the minimum return that a company need to make to make sure that it satisfies its stockholders, preferred stockholders, and bondholders. The IRR, on the other hand, is the discount rate that is used in capital budgeting that makes the NPV of the cash flow from a project equal to zero. From the calculations, it is evident that Vestor company has a higher IRR or 14.90% to the WACC of 9.10% this indicates that the organization needs to take up the project. In general projects with a higher IRR or where the IRR is equal to the WACC, the projects should be accepted. Because the IRR is greater than the Vestore firm should take the project because it will make a profit of 2,4% and result in a benefit to the organization.
| A | B | C | D | C*D |
| Source of Capital | Market Value | Weight in capital structure | Cost Component | WAAC |
| Bonds | $10,000,000 | 50.00% | 4.26% | 2.13% |
| Proffered Stock | $2,000,000 | 10.00% | 10.00% | 1.00% |
| Common stock | $8,000,000 | 40.00% | 14.92% | 5.97% |
| Total | $20,000,000 | 1000.00% | 9.10% |
| COST OF BONDS | |
| Maturity | 20 |
| Current Market Price | 950.00 |
| Par Value | 1,000.00% |
| Coupon Rate | 6.00% |
| Annual Coupon Payment | 60.00 |
| Pre-Tax Cost of Debt | 6.45% |
| After-Tax Cost of Debt | 4.26% |
| COST OF PREFERRED STOCK | |
| Preferred Dividend | 2.50 |
| Market Price of Preferred Stock | 25.00 |
| Cost of Preferred Stock | 10.00% |
| COST OF COMMON STOCKS (BASED ON CAPM APPROACH) | |
| Market Return | 13.00% |
| Risk- Free Rate | 3.50% |
| Market Risk Premium | 9.50% |
| Beta of P&G | 1.2 |
| Equity Risk Premium | 11.40% |
| Cost of Common Stocks (Equity) | 14.90% |
| WACC CALCULATION | ||||||
| Sources | Market Value | Weight | Cost of Fund | Tax Return | After- Tax Cost of Fund | Weighted Average Cost |
| Bonds | 10,000,000 | 50.00% | 6.45% | 34.0% | 4.26% | 2.13% |
| Preferred Stock | 20,000,000 | 10.00% | 10.00% | 1.00% | ||
| Common Stock | 80,000,000 | 40.00% | 14.90% | 5.97% | ||
| WACC | 9.10% | |||||
Reference
Brotherson, W. T., Eades, K. M., Harris, R. S., & Higgins, R. C. (2015). 'Best Practices' in Estimating the Cost of Capital: An Update.
Krüger, P., Landier, A., & Thesmar, D. (2015). The WACC fallacy: The real effects of using a unique discount rate. The Journal of Finance , 70 (3), 1253-1285.
