Question 3 Chinatown Electric Corporation (CEC) is a utility company providing e

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Question 3

Chinatown Electric Corporation (CEC) is a utility company providing electricity to households in Kowloon. The business of CEC has been stagnant in recent years and the board of directors wants to increase the company’s revenue by investing overseas. One of the possible projects is to generate electricity in Taipa, Macau. The management believes this project can bring a substantial revenue to the company in the future.

As a CEC business analyst, you have been asked by the board to determine an appropriate discount rate to evaluate this electricity project. From your study in FIN B280, you think the first step is to identify the weighted average cost of capital (WACC) of your company. The information about the current capital structure of CEC is as follows:

i 1,000,000 shares of common stock with a par value of $1.0, currently trading at $20 per share.

ii 1,000,000 shares of 6% preferred stock with a par value of $12. These preferred stocks are currently trading at $10 per share in the market.

iii 8,000 units of ten-years, 4% p.a. coupon bonds with a semi-annual interest payment. The bond has exactly four years to maturity with a par value of $1,000. The current quotation for this bond is 100.00, which means 100% of its par value. Bonds with a similar risk, interest term and maturity are currently selling at 4.0% p.a. yield to maturity.

iv A $12,000,000 long-term bullet payment loan with Open Bank. The loan was borrowed six months ago with a 5% p.a. borrowing rate. The market value of this bank loan is not available.

v The expected market return is 8%, the risk-free rate is 2% and the beta of CEC’s common stock is 1.2 respectively. The marginal tax rate is 25%.

Answer the following questions:

a What is the capital structure of CEC on a market value basis? Please make assumptions in your calculation, if necessary.

b Evaluate the weighted average cost of CEC’s capital (WACC).

c Under what condition is it suitable for a company to use its WACC as a benchmark to evaluate investments? What potential mistakes can this company make if such a condition is being violated?

Explanation / Answer

*For bond and bank loan, the cost is taken as cost * (1-Tax rate).

c) WACC analysis can be looked at from two angles – the investor and the company. From the company’s angle, it can be defined as the blended cost of capital which the company has to pay for using the capital of both owners and debt holders. In other words, it is the minimum rate of return a company should earn to create value for the investors. From investor’s angle, it is the opportunity cost of their capital. If the return offered by company is less than its WACC, it is destroying value and hence the investors may discontinue their investment in the company.

Hence, it is suitable for a company to use its WACC when the company's capital structure is leveraged.

Secondly, if such conditions are violated then this company would not be able to evaluate the actual amount of minimum rate of return it needs to fetch for the feasibility of the expansion programme.

a) Capital Structure of CEC on a market value basis : Market Value Quantity Product Weights 1. Common Stock $20 1000000 $20,000,000 46.728972 2. 6% Preferred Stock $10 1000000 $10,000,000 23.364486 3. Bonds $100 8000 $800,000 1.86915888 4. Bank Loan - - $12,000,000 28.0373832 TOTAL $42,800,000 100

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