Abco distribution ltd wishes to evaluate an investment in a new era of activity-

Question

Abco distribution ltd wishes to evaluate an investment in a new era of activity-- manufacturing paint. Bath paints (BP) has been indentified as a company whose sole activity is to produce oaint. The systematic risk of BP's equity is 1.2 . Howecer BP is financed by one part debt to one part equity, whereas Abco Distributors is financed by two parts debt to three parts equity. Further, Abco's management has estimated the risk-free interest rate to be 12 percent and the expected rate of return on the market portfolio( including the franking premium) to be 17 percent. The company income tax rate is 30 cents in the dollar. The propotion of tax collected from the company that is claimed by shareholders is 0.60, and the before- tax cost of Abco's debt is 14 percent per annum. Calculate the cost of capital of the proposed new project, specifying the assumptions on which your calculations are based.

Explanation / Answer

Systematic risk of BP’s equity is 1.2

Stock Beta = 1.2

BP is financed by one part debt to one part equity;

Debt portion = ½ = 0.50

Equity portion = ½ = 0.50

New Project: Abco Distributors Project

Risk-free interest rate (Rf) = 12%

Expected rate of return on the market portfolio (RM) = 17%

Income tax rate = 30%

Before-tax cost of Debt = 14%

Abco Distributors is financed by two parts debt to three parts equity;

Debt = 2/5 = 0.40

Equity = 3/5 = 0.60

Weighted Average Cost of Capital Calculation (WACC):

WACC = (E/V) * RE + (D/V) * RD (1-Tc)

(E/V) = 0.60

(D/V) = 0.40

Cost of Common Equity (According to CAPM):

Cost of Common Equity (RE) = Rf + (RM – Rf)

Cost of Common Equity (RE) = 0.12 + 1.2 (0.17 – 0.12)

Cost of Common Equity (RE) = 0.12 + 0.06

Cost of Common Equity (RE) = 0.18 (or) 18%

Cost of Debt = 14%

WACC = [(0.60 * 0.18) + {0.40 * 0.14 (1-0.30)}]

WACC = [0.108 + {0.40 * 0.098}]

WACC = [0.108 + 0.0392]

WACC = 0.1472 (or) 14.72%

Cost of Capital of the proposed new project = 14.72%

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