Question 1: Weighted Average Cost of Capital (WACc) Geotech Consulting is a priv

Question

Question 1: Weighted Average Cost of Capital (WACc) Geotech Consulting is a privately owned geological consultancy and research facility based in Hamilton. The company has been investigating a number of projects but has been unable to accurately calculate an appropriate benchmark rate for measuring these projects. You have been supplied with the following information and asked to calculate the weighted average cost of capital (WACC) for the company Geotech Consulting Statement of Financial Position (extract from 30 June 2014 accounts) Common Stock par value $2.00 14% Preference Shares par value $3.00 12% Bonds semi-annual (face value $100) 4,000,000 3,000,000 2,000,000 350,000 700,000 Term Loan Mortgage loan Additional Information: The ordinary shares are currently trading at $2.86 while the Preference shares are trading at $3.15 Return on government bonds is 4%, the market risk premium 6%. A consultant has estimated the company to have a beta of 1.3. Corporate tax rate is 35% The bonds originally had a 6 year term to maturity and were issued exactly two years ago and would be redeemed at par. " The before tax return on similar risk bonds is 9% . Interest on the term loan is 10% and the Mortgage is 9%.

Explanation / Answer

Let us first calculate cost component of each source of capital

Cost of equity = Risk free rate of return + beta( Risk premium)

=4%+1.3(6%)

=4%+7.8%

=11.8%

Cost of preference capital = Dividend/Price of pref shares

=(3*0.14)/3.15

=0.42/3.15

=13.33%

Cost of bonds = Interest on similar bond(ie YTM) * (1-tax rate)

=9%(1-0.35)

=9%(0.65)

=5.85%

Here we need to find market value of bond

Value = Interest*PVIFA(YTM%,n) + redemption value*PVIF(YTM%,n)

=Interest = 100*12%*1/2 = 6$

YTM = 9%/2 = 4.5%

n = 4*2 = 8

Value = 6*PVIFA(4.5%,8) + 100*PVIF(4.5%,8)

=6*6.595886 + 100*0.703185

=39.575+70.318

=109.89$

Cost of term loan = interest rate(1-tax rate)

=10%(0.65)

=6.5%

Cost of mortagae loan = Interest rate(1-tax rate)

=9%(0.65)

=5.85%

Statement showing WACC

Source of capital Market value Weightage K WACC = W*K Equity 5720000 47.1% 11.80% 5.56% Preference 3180000 26.2% 13.33% 3.49% Bond 2197800 18.1% 5.85% 1.06% Term loan 350000 2.9% 6.50% 0.19% Mortagage Loan 700000 5.8% 5.85% 0.34% 12147800 10.63%

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