Cost of Capital Calculation and Analysis

The assignment focuses on calculating the various components of the cost of capital: debt, preferred stock, and equity. It then determines the Weighted Average Cost of Capital (WACC) using the calculated individual costs. The document also explains the significance of WACC as a discount rate in project evaluation under capital budgeting. It clarifies when WACC is appropriate as a discount rate and discusses alternative approaches for projects with differing risk profiles.

Cost of Capital
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Cost of debt
Face value of debt = $1,800,000
Maturity = 2 years
Coupon rate = 5.8% p.a paid semi annually
The debt rating of the company is AAA, hence according to the credit rating table the yield
on bond for 2 years is 0.26%.
Cost of debt = 0.26%
Cost of Preference share
Annual dividend = $0.56
Price of share = $9.30
Cost of preferred capital = annual dividend / price of share
= 0.56 / 9.3
= 6%
Cost of Equity
Risk free rate is considered as the 10 year yield on AAA rated bond which is 0.76%.
Beta = 1.4
Market risk premium = 9.6%
Cost of equity = Rf + (Beta * market risk premium)
= 0.76% + (1.4*9.6%)
= 13.7%
For weights of each capital, the market value is determined as follows:
Market value of debt
Price of bond = C*F * ((1-(1+r)-t) / r

= 0.029 * 1800000 * ((1-(1+0.0026)-4) / 0.0026
= $207,449.8
Market value of preferred capital
No. of shares = 400,000
Market value = 400000 * 9.3
= 3,720,000
Market value of equity
Dividend = $0.72
Growth rate for next three years = 8%
Constant growth rate = 2%
Year Growth rate Dividend
0 $0.72
1 8% $0.78
2 8% $0.84
3 8% $0.91
4 2% $0.93
Price of share = expected dividend / (cost of equity – growth rate)
Price of share at end of 3rd year = 0.93 / (13.7% - 2%)
= $7.95
Present value of cash flows
Year Cash Flow Present value
1 $0.78 $0.68
2 $0.84 $0.65
3 $0.91 $0.62
3 $7.95 $5.41
Total present value $7.36

No. of equity share = 1700000
Market value of equity = 1700000 * 7.36
= $12,509,137
WACC
Capital Market Value Weights
Cost of
capital
Weighted cost
of capital
Debt $2,07,449.80 0.01 0.0026 0.00003
Preferred capital $37,20,000.00 0.23 0.06 0.01358
Equity $1,25,09,137.26 0.76 0.137 0.10426
$1,64,36,587.06 1 11.8%
Hence the WACC is 11.8%
WACC as the discount rate
Weighted average cost of capital is the cost of capital of a company that takes into
consideration the cost of all the sources of capital used in a business for funding projects and
investments. The sources of funds available to a business are debt, equity, preferred stock and
retained earnings. Equity is generally the most expensive source of finance and retained
earnings the cheapest. WACC shows the interest that the company will have to pay for every
dollar invested. The equity holder and debt holders expect a return on their investment and
this cost of capital measures the expected returns of the equity and debt holders. WACC is
the minimum return that the company should produce for its investors.
While evaluating a project under capital budgeting, a cost of capital is required to discount
the cash flows to their present value because the rate used to discount the cash flows should
represent the expected after tax returns of the different providers of capital. This is to see if
the project gives a positive NPV and also two similar projects with different time frame can
be compared using a discount rate as all the cash flows are discounted to the present (Young,
2002) In general the companies mostly use WACC as that cost of capital. This is because
WACC incorporates all the risk associated with the different sources of finance like debt and
equity. When the company is undertaking a project of similar risk as that of the existing
projects of the company, it is appropriate to use the WACC as the discount rate. For example,
a manufacturer of textiles increases the number of looms from 650 to 100, in this case the

industry and the business is the same and there is no change in risk, hence it is preferable to
use WACC as the cost of capital. This also means that as a result of the new project, there is
no change in the capital structure of the company. This means the ratio of debt and equity
should not change due to the new project and should be what it was in the balance sheet.
However, WACC cannot be used as a discount rate for projects with a risk different from the
existing projects risks. In such cases, the WACC of the company similar to the new project
should be taken into consideration or the cost of equity can be calculated using the CAPM
model. For riskier projects, a higher discount rate may be used and for less risky projects, a
lower discount rate should be used.
Bibliography
Young, L. (2002, September). Determining the Discount Rate forGovernemnt Projects. New Zealand
Treasury: Working Paper 2/21.