You have been provided with the following information on C-B P/L which has the f

Question

You have been provided with the following information on C-B P/L which has the following on its books; Book value Market value Cost of Capital (After-tax cost) Long-term debt Ordinary equity Preference capital $ 750,000 $ 450,000 $ 300,000 $780,000 $600,000 $400,000 6.8% 8.4% a) What is the WACC % (using the BV weights)? (4 marks) b) What is the cost of capital and what is the role that it plays in making long-term investment decisions? (4 marks) c) Why is the cost of equity higher than long or short-term debt? (2 marks)

Explanation / Answer

a) WACC (by book value weights) = Weight of debt * After tax cost of debt + Weight of common equity * Cost of common equity + Weight of preferred equity * Cost of preferred equity

Weight of debt = 750000/(750000 + 450000 + 300000) = 50%

Weight of ordinary equity = 450000/(750000 + 450000 + 300000) = 30%

Weight of preferred equity = 300000/(750000 + 450000 + 300000) = 20%

WACC = (50% * 6.8%) + (30% * 8.4%) + (20% * 7.1%) = 7.34%

b) Cost of capital is the cost of investment made by the company by using different forms of capital - debt, common stock and preferred equity. So, this is the financial cost of investment. Now, the basic financial principle says that for a project to be profitable, return generated by investment should be higher than the cost of invested funds.

So, another way to look at the cost of capital is that it is the minimum return or the hurdle rate that needs to be generated by the project in which funds are invested for the project to be profitable and value-add for the firm.

Now, when firm see the cashflows that are generated by the project have an Internal Rate of Return (IRR) greater than the cost of capital or WACC, the project would be profitable. If the IRR is less than WACC, the project in review is not profitable and should not be invested into. Such project may decrease the value of firm. Hence the WACC is used for capital budgeting decisions as well as allocation of capital in multiple projects.

WACC also helps in deciding the optimal capital structure to be used for a project such that the returns are enough to cover the cost.

c) Cost of Equity is higher than the cost of long or short-term debt. This can be explained by the risk inherent in these capital forms. By basic financial principle, higher risk demands higher required rate of return.

Debt lenders have the first lien on assets of the company. In case of financial distress or liquidation, debt holders will be first paid from the assets. Even the debt holders need to be paid the interest expense first before payments of dividend to the common stock holders.

Shareholders will get their share of assets only after lenders will be paid - whether it is debt interest service or whether it is payment post liquidation. Since shareholders carry higher risk of default from the company, than debt holders, correspondingly, their required rate of return or cost is higher.

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