Berkshire Instruments: WACC Calculation, Analysis, and Recommendations

This project analyzes the Weighted Average Cost of Capital (WACC) for Berkshire Instruments, a financial analysis project. The assignment calculates WACC using two methods: retained earnings and new equity. It includes the determination of the cost of debt, cost of preferred stock, and cost of equity. The project provides detailed calculations and analysis, comparing the WACC under both methods and offering recommendations based on the findings. The analysis considers the weights of each component in the capital structure and discusses the importance of using current costs rather than historical costs. The project also provides a discussion on retained earnings versus new equity as a source of financing. The conclusion recommends the most efficient method of WACC calculation based on the analysis.

Running Head: Berkshire Instruments 1
Berkshire Instruments
[Name of Writer]
[Name of Institution]

Berkshire Instruments 2
Question 1
Part 1
WACC Based on retained earning
Cost components of capital structure
a) Cost of debt: -
Maturity 20
Interest 9.30%
Per value 1000
Market Value 890
Per year interest = 1000*9.3% = 93
Cost of debt after tax = 9.3% * (1-35%)
Cost of debt after tax = 9.3%X (.65)
= 6.045
Weight of Debt = Total debt/ Long term capital
= 6,120,000 / 18,000,000
= 0.34
b) Cost of preferred stock: -
Market price = 60
Annual dividend = 4.8
Floating cost = 2.6
Net price of preferred stock = 60-2.6
= 57.4
Cost of Preferred Stock = 4.8 / 57.4
= 8.36

Berkshire Instruments 3
Weight of Proffered stock = Total preferred stock / long term capital
= 1,080,000 / 18,000,000
= 6%
C) Cost of Retained Earning: -
Using dividend discount model,
C = (Dividend + Growth rate) / Market price
Dividend = 3 * 40%= 1.2
Market price = 25
G =?
Dividend growth 1.2 in 4 years’ dividend current= 0.82
Using compound interest formula
1.2 = 0.82 (1+g)4
1.2/.82 = (1+g)4
(1.4634)1/4 = (1+g)4x1/4
G = 10%
Now cost of equity = 1.2/25 + 10%
= 14.80%
Weight of Equity = 1,080,000 / 18,000,000
= 6%
So therefore WACC would be
Cost Weight Cost *
Weight
WACC
Debt 6.045% 34% 2.0553 11.4369
P Stock 8.36% 6% 0.5016
C Stock 14.8% 60% 8.88

Berkshire Instruments 4
The weighted average cost of capital is 11.43% based on retained earnings method.
Part-2
WACC using new equity
Price =25
Floating Cost =2 (on new issue)
Net price =25-2
= 23
Now cost of equity = 1.2/23+10%
= 15.2%
Revised WACC using equity: -
Cost Weights Cost * Weight WACC
Debt 6.045% 34% 2.0553 11.6769
P Stock 8.36% 6% 0.5016
C Stock 15.2% 60% 9.12
The WACC is 11.6769% based on new equity

Berkshire Instruments 5
Part 3:
A.
Weighted average cost of capital is weighted cost of sources of finance. While calculating
this figure we need cost of each component in capital structure. Apart from debt and preferred
stock, third most important component of capital structure is cost of equity. Depending on the
policies of management, it can be retained earnings or new equity. Profit or net income earned
through operations can be paid as dividend or retained (Ball, Gerakos, Linnainmaa & Nikolaev,
2019). In first method, WACC is calculated using retained earnings. methods, the cost of equity
calculated taking into account the growth rate of dividend over the years. Retained earnings is
also called internal financing because it does not involve cost. While in second method WACC is
calculated through new equity, the cost of equity is calculated after adjusting any floating cost.
The issue of new common stock incurs cost of placement or fee of intermediary financial
institutes.
B.
Weighted average cost of capital is average cost of financing from different sources
(Frank & Shen, 2016). Lower weighted average cost is preferred and is only possible when each
component of capital structure is financed with lower cost. According to findings in above
calculations, it is suggested that weighted average cost of capital (First Method) based on the
retained earnings is best option. Retained earnings is profit that is retained for reinvestment for
company projects. The reason of suggesting WACC based on retained earnings (First Method)
over new equity (New Equity) is lower cost. WACC under first method is 11.4369% while it is
11.6769% under second method.

Berkshire Instruments 6

Berkshire Instruments 7
References
Ball, R., Gerakos, J. J., Linnainmaa, J. T., & Nikolaev, V. V. (2019). Earnings, retained earnings, and
book-to-market in the cross section of expected returns. Journal of Financial Economics (JFE),
Forthcoming. https://www8.gsb.columbia.edu/faculty-research/sites/faculty-research/files/
GERAKOS%20RetainedEarnings20170925.pdf
Frank, M. Z., & Shen, T. (2016). Investment and the weighted average cost of capital. Journal of
Financial Economics, 119(2), 300-315.
https://www.sciencedirect.com/science/article/pii/S0304405X15001683