BioCom, Inc.: A Fresh Look at the WACC BioCom, Inc. is weighing a proposal to ma

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BioCom, Inc.: A Fresh Look at the WACC

BioCom, Inc. is weighing a proposal to manufacture and market a fiber-optic device that will continuously monitor blood pressure during cardiovascular surgery and other medical procedures in which precise, real-time measurements are critical. The device will continuously transmit information to a computer via a thin fiber-optic cable and display measurements on several large monitors in view of operating room personnel. It will also store the data and display it graphically for review during or after procedures.

A recently hired financial analyst who is working on her MBA asks how the company arrived at 9% as the discount rate to use when evaluating capital budgeting projects. Her question is followed by an embarrassing silence that seems to last forever. Eventually, the comptroller, who has been with the company for many years, offers an explanation. When the company first began to use discounted cash flow methods for capital budgeting decisions in the 1980s, it hired a consultant to explain internal rate of return and net present value. The consultant used 10% in all his examples, so BioCom did the same. By the late 1990s, interest rates had fallen considerably and the company was rejecting some seemingly profitable projects because the hurdle rate was too high, so it lowered it to 9%. As far as he knew, that was the end of the story.

Interestingly, many participants in the discussion

Explanation / Answer

1)

1031 = 35 * PVIFA(r%,12) + 1000 * PVIF(r%,12)

r= 3.19%

bond 1 YTM = 2* 3.19 = 6.38%

after tax cost of debt = 6.38 * (1-0.34) = 4.2108% = 4.21%

for bond 2

1035 = 40 * PVIFA(r%,12) + 1000 * PVIFA(r%,12)

r= 3.63%

bond 1 YTM = 2* 3.63 = 7.26%

after tax cost of debt = 7.26 * (1-0.34) = 4.7916% = 4.79%

2)

19 = 1.5/p

cost of preferred stock p = 7.90%

3)

using security line

cost of equity = 3% + 1.2 * (12%-3%) = 13.80%

using dividend model

35 = 2.5 * 1.06/r -6%

cost of equity = 13.57%

cost of common equity = (13.57 + 13.80)/2 =13.685% = 13.69%

4)

should use market values

WACC = 0.15 * 4.21% + 0.20 * 4.79% + 0.10 * 7.90% + 0.55 * 13.69%

= 9.91%

6)

No , it should adjust its cost of capital to different levels of risk

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