Fundamentals of Finance and Accounting

FUNDAMENTAL OF
FINANCE

Introduction
Project evaluation is one of the key management process of an entity for various reasons, the
chief being the huge investments and the resources involved, and the fact that the
organisation does not has an option to reverse the decision once taken (Berman, Knight and
Case, 2013). The aim of the following report is to guide the entity Chowkidar Plc regarding
the suitability of the two mutually project proposals before the entity. The report would shed
light on the varied aspects of the project evaluation such as the cost of capital to be used,
elaboration of the appraisal techniques for the evaluation of the projects, the potential issues
in the techniques and the recommendation for the future course of action.
Weighted Average Cost of Capital
Weighted Average Cost of Capital denotes the collective average cost of different sources of
finance in the entity that are the debt, equity shares, mezzanine financing (Ross, et. al, 2014).
In the scenario in the consideration, the management of the entity desires to maintain the
book value weights in the capital structure, and hence the book value weights have been used
for the computation of the cost of capital. The weighted average cost of capital has been
computed as follows.
In the first step, the individual cost for the individual sources of finance has been calculated,
as depicted below. The formula used for the cost of equity is the Gordon’s Growth Model.
Calculation of cost of equity
Ke (Cost of equity ) = (D *(1 + g))/ P + g
Where,
D = Dividend last paid
G = Growth Rate
P = Current market price
G = 4.55%
Ke (Cost of equity ) = ((0.14*(1 + 4.55%)) /100) + 4.55%
Ke (Cost of equity ) = 4.6964%
Ke = 4.70%

The formula for yield to maturity has been used to compute the cost of capital as listed below.
Calculation of cost of debt
Coupon per bond (C) = 4%
Coupon per bond (C) = 4.00
Face Value of Bond (FV) = 100
t = 7
Market Price (PV) = 91.5
Kd = (4 + ((100-91.50)/7))/((100+91.50)/2)
Kd = 0.054457292
Kd = 5.45%
Kd (after tax) = 4.41%
Thus, the combined cost of capital on the basis of the book value weights has been calculated
as follows.
Computation of WACC
Ratio of bonds = 0.59
Ratio of mezzanine finance = 0.4
Ratio of equity = 0.1
Cost of Equity = 4.70%
Cost of Debt = 4.41%
Cost of Mezzanine Finance = 8%
WACC = 3.93%
In contrast to this, the cost of mezzanine financing is 8% which is much higher than the
overall weighted average cost of capital which is 3.93%. In the opinion of the Chief
Accountant of the company, weighted average cost of capital is more suitable, in contrast to
the views of the Chairman of the entity. Indeed, the weighted average cost of capital is the
appropriate cost for the evaluation of the proposal of the entity. This is because, though the
project would be solely financed by the Mezzanine financing, the inclusion of more of