Introduction
The WACC is an essential metric tool in the capital structure of the company. It is used to measure the potential impact of the anticipated project on the growth of the business. In this sense, it provides the benchmark of making a decision whether the project is profitable for the company. If the project’s rate of return is less than the WACC, the company should reject the project. However, in cases where the rate of turn is greater than WACC, this means that the anticipated project would have a positive NPV. The company should divert its resources and invest in such a project.
In this scenario, the cost of equity of the Vestor Corporation will be calculated using CAPM. It is a model that is used when evaluating a risky investment. Further, it is helpful in calculating the anticipated rate of returns on the inherent risk of the project. The CAPM calculations require three inputs which include the risk-free security rate of return, market return expected, and a beta of the asset. In other words, it is the sum of risk premium and the rate of return of the risk-free asset. The risk premium is the difference between the expected rate of market return and risk-free rate multiplied by the beta.
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Below is the calculation of the cost of equity using investment’s fair price.
CAPM = Ke = r rf + B a (r m -r rf )
Whereby: r rf = Is the risk-free rate
R m = Market rate of return
B a = Beta of the Asset
Ke = 3.5% + 1.2 (13-3.5) = 14.9%
WACC = Wd x Kd + We x Ke
Where Wd is the weight of debt and We is the Weight of equity
WACC = [(1000000/2000000) x 6.45 x (1-.35)] + (10 x 2000000/2000000) + (14.9 x 800000/2000000) = 9.10%
Alternatively, WACC can be calculated as:
Vestor Warehouse Investment Assessment
In the investors point of view, WACC is the minimum return that a company may earn from a project or investment. Similarly, investors, bondholders, stockholders, and preferred stockholders would use this rate or return to make their investment decisions. On the other hand, IRR is the rate of return that is applied when estimating the break-even point of an investment. It is the rate that equates the NPV into zero. Further, at this point the discounted cash flows of the investment are equal to initial cash outlay.
11.5% is the expected rate for the Vestor Corporation and the expected WACC is 9.10%. In general, it is financial logical that the returns from the investment should be greater than overall cost. In this case, the expected IRR is greater than WACC and thus, it is feasible for the Vestor to accept warehouse investment. In the long run or after the maturity of the project, the company is expected to make a profit of 2.4% which is the difference between the overall costs and the minimum expected returns (11.5% – 9.10%). Alternatively, given sufficient information, there are different areas to consider when assessing the feasibility of a project. For instance, it is important to consider the compatibility of the project and the operation of the company.
Conclusion
Through the evaluation of the overall cost of capital using CAPM, the anticipated warehouse project has shown positive NPV. However, there is the importance of understanding the overall impact and financial component of the company. With this, the company will not be exposed to the risk of bankruptcy after exhausting all the resources while attempting to fund products. More often, the financial benefits of such projects are long-run and thus, the company should utilize all the liquid resources expecting immediate returns.
