During the last few years, Malware Solution Industries has been too constrained

Question

During the last few years, Malware Solution Industries has been too constrained by the high cost of capital to make many capital investments. Recently, though, capital costs have been declining, and the company has decided to look seriously at a major expansion program proposed by the marketing department. John Carter who is an assistant to Mary Ward, the financial vice president is asked to estimate Malware Solution’s cost of capital. Ward provides Carter with the following data.

1. The firm’s tax rate is 40%.

2. The firm has 10% annual coupon bonds with 15 years remaining to maturity. The current price of the bond is $1, 096.26. The bond’s yield-to-maturity is 8.82%.

3. The firm’s balance sheet shows $100 million long-term debt and $300 million common equity.

Ward estimates the market risk premium as the historical average return on stocks minus the current return on Treasury bonds and obtains a 15.4% of the cost of common stock based on the CAPM.

Ward calculates the firm’s weighted average cost of capital (WACC) as follows:

Weight of long-term debt is .25 (=100/400)

Weight of common equity is .75 (=300/400)

WACC = .25 x 10% x (1 - .4) + .75 x 15.4% = 13.05%

Questions :

1. Find problems inherent in Ward’s WACC calculation.

2. What can you suggest to solve problems found in Question 1?

3. Ward used the CAPM to estimate the cost of common stock. What can you propose to get the best estimate for the cost of common stock?

4. How confident can you be with the WACC based on solutions you suggested through the evaluative process in terms of the firm’s divisions and projects? What issues should be considered?

I need details and explication.

Thank you!

Explanation / Answer

1. WACC = E / V * Re + D / V * Rd * (1 Tc)

            = 300 / 400 * 15.4% + 100 / 400 * 10% ( 100% - 40%) * (1 - 40%)

            = 0.75 * 0.154 + 0.25 * 0.10 (0.60) * (0.60)

           = 0.1155 + 0.009 = 0.1245 or 12.45%

But as per Ward's WACC calculation, it is 13.05%

2. Ward's formula for calculating WACC is wrong. She has to change the formula as mentioned above.

3. Cost of common stock can be best estimated by CAPM method.

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