As Chief Economic Adviser at BigOil Company, you are also the company’s Chief Fi

Question

As Chief Economic Adviser at BigOil Company, you are also the company’s Chief Financial Officer. Your company has launched an ambitious capital investment program, and the Board of Directors has assigned to you the task of estimating the company’s cost of capital. You take this assignment seriously and decided to do the work yourself. Suppose that one of your assistants has collected the following data for BigOil Company.

• The company’s capital structure (mix of debt and equity) is composed of: Debt (D) = $385.7M and Common stock (E) = $1,200.0M

• The cost of debt can be estimated using the cost of bonds (the principal component in the company’s debt), which has the following characteristics: - Face Value = $1,000; - Coupon rate = 6%, paid annually; - Time to maturity = 10 years; - The bonds currently trade for $807.47; - BigOil’s corporate tax rate (Tc) = 35%.

• The cost of equity can be estimated using CAPM, assuming the following data: - Return on the risk-free security (e.g., 10-year US government note) = 3%; - Return on the market index (e.g., S&P500) = 11.2%; - BigOil’s Beta () = 1.1.

Suppose that BigOil needed to evaluate a project with the same risk as its existing business that would support a 24.3% debt ratio. What should be the discount rate to be used for the cash flows from this project?

What might be the issue(s) with the reasoning in part (C)?

Explanation / Answer

1) Cost of capital :

Cost of equity -

Re = rf + (rm – rf) *

= 3% + (11.2%- 3%) * 1.1

= 3% + 9.02%

= 12.02%

Cost of debt =

Rd = Interest rate ( 1- Tax)

= 6% ( 1 - 0.35)

= 3.9%

We = $1200/ $1585.7

= 0.76

Wd = $385.7/ $ 1585.7

= 0.24

Cost of capital =

WACC = Ke * We + Kd * Wd

= 12.02 % * 0.76 + 3.9% * 0.24

= 9.1352 % + 0.936%

= 10.071 %

Evaluate a project with the same risk as its existing business that would support a 24.3% debt ratio::---

WACC where debt ratio 24.3 % , thus equity share will be 75.7 %

WACC = Ke * We + Kd * Wd

= 12.02 % * 0.757 + 3.9% * 0.243

= 9.099 % + 0.9477 %

= 10.046 %

Discount rate to be used for the cash flow where the WACC remain same as old 10.071%

WACC = Ke * We +( Kd * Wd * (1- tax))

10.071 % = 12.02% * 0.757 + ( Kd * 0.243 ( 1- 0.35))

10.071 % = 9.099 % + 0.158Kd

Kd = 6.15 %

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