Calculation of Company’s WACC and Evaluation of a Project

This article explains how to calculate a company's WACC and evaluate a project using NPV, IRR, and payback period. It covers the inputs required for WACC calculation and how to use it as project WACC. It also provides insights into the relevant project details and incremental project flows.

Calculation of Company’s WACC
Cost of preference shares
Unit price of preference shares = $ 9.56
Dividend per preference share = $ 0.93
Hence, cost of preference shares = (0.93/9.56)*100 = 9.73% p.a.
Cost of Equity Shares
The cost of equity shares can be estimated using the CAPM model
As per this model,
Cost of Equity = Risk Free Rate + Beta * Risk Premium
The inputs required above are indicated below.
Risk free Rate (10 year treasury bond yield) = 2.785%
Beta of stock = 1.4
Market Risk Premium = 9.1% p.a.
Hence, cost of equity = 2.785 + 1.4*9.1 = 15.53% p.a.
Cost of Bonds
The bonds of the company pay a coupon of 3.6% p.a. which is payable on a quarterly basis.
Hence, effective annual rate (EAR) = (1+(3.6/400)4 -1 = 3.65% p.a.
After tax cost of debt = 3.65*(1-0.3) = 2.55% p.a.
Market value of Preference Shares
Number of preference shares issued = 800000
Unit price = $ 9.56
Market value of preference shares = 800000*9.56 = $7,648,000 or $7.648 million

Market value of Ordinary Shares
This can be found out using the Gordon dividend model.
Dividend (t=1) = 0.5*1.09 = $0.545
Dividend (t=2) = 0.545*1.09 = $0.594
Dividend (t=3) = $ 0.594*1.09 = $0.648
Dividend (t=4) = 0.648*1.09 = $0.706
Dividend (t=5) = 0.706*1.02 = $0.72
Hence, intrinsic cost of a share = (0.545/1.1553) + (0.594/1.15532) + (0.648/1.15533) +
(0.706/1.15534) + (0.72/[(0.1553-0.02)(1.15534] = $4.32
Number of ordinary shares issued = 1,100,000
Hence, market value of shares issued = 1.1 million *4.32 = $4.75 million
Market Value of Bonds
Face value of bonds = $ 1.2 million
Maturity time = 6 years
Coupon rate = 3.6% p.a. payable quarterly or 0.9% per quarter
Hence, coupon payable quarterly = 0.9% * 1.2 million = $0.0108 million
YTM = 2.52 + 0.55 = 3.07% p.a.
Considering the above discount rate, the market value of the bond can be derived as shown
below.

Hence, market value of bonds would be $ 1,235 million
Total capital = 1.235 + 4.75 + 7.648 = $13.633 million
Weight of preference shares = (7.648/13.633) = 0.561
Weight of ordinary shares = (4.75/13.633) = 0.348
Weight of bonds = (1.235/13.633) = 0.09
Hence, WACC = 0.561*9.73 + 0.348*15.53 + 0.09*2.55 = 11.10%
Usage of Firm WACC as Project WACC
It must be understood that WACC is a function of the underlying risk associated with the
given project. Thus, for a project which has the risk level similar to that of the firm’s average

projects, then it is appropriate to use the firm’s WACC as the project WACC. However, if the
risk level is higher and lower, then suitable adjustments ought to be made to the project
WACC.
Relevant Project Details
The following points about the given project are noteworthy.
 The cost associated with feasibility study would be considered as sunk cost since it has
already been incurred.
 Also, the depreciation expense would be levied on a diminishing value basis and after four
years the book value of the equipment would be zero
Hence, depreciation in year 1= (2/4)*18000 = $9,000
Depreciation in year 2 = (2/4*(18000-9000) = $ 4,500
Depreciation in year 3= (2/4)*(9000-4500) = $ 2,250
Depreciation in year 4 = $ 2,250 (remainder value to be depreciated)
 It is known that building in which the project would be set up is currently on rent. Thus,
there would be an opportunity cost associated since there would be a loss of rent.
 Also, while the book value of the equipment at t=4 has been reduced to $0. However, the
equipment is sold in the last year for a value of $2,500. Therefore, there are gains made
which would be taxed at 30%.
The incremental project flows are highlighted below.

Computation of NPV
Using a discount rate of 11.1%, the NPV has been computed as shown below.
Computation of IRR

IRR computation is shown below.
IRR = 11.07%
Computation of Payback Period
The payback for the project is computed from the following table.
Payback period = 3+ (1728/6959) = 3.25 years
Evaluation of Projects
NPV and IRR are superior measures in comparison to payback period considering that
payback period does not use discounted cash flows and hence ignores the time value of
money. However, considering the company uses the payback period also, it would be used as
a supplementary measure to aid the more superior options.

Recommendation
Based on the above computations, it is apparent that the project would be rejected owing to
the following reasons.
1) The NPV of the project is negative and hence it would destroy the wealth of
shareholders.
2) The IRR is lower than the discount rate.
3) The payback period of the project exceeds 3 years.