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. I really need full details and full explication.

Thank you!

Explanation / Answer

1. Problem inherent in ward,s WACC calculation is the interest rate taken for debt, it should beYeild to maturity for calculating WACC.

2 WACC = .25 x 8.82% x (1 - .4) + .75 x 15.4% = 12.87%

WACC => 12.87%

3. Each method has its strengths and weaknesses, and all are subject to the quality of the inputs.CAPM depends upon an accurate estimate of the firm’s beta. Estimating the cost of equity is one of the most difficult tasks in finance. DIVIDEND DISCOUNT MODEL and DEBT RISK PREMIUM MODEL can be used to calculate cost of equity .

The best way is to calculate from all the methods and in which it varies the most that method should be eliminated,

ill suggets to go for dividend discount model

4. WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers.

First, management must determine the project or division's risk as compared to the overall risk of the firm. A higher-risk project requires a discount rate that is higher than the WACC; a lower-risk project requires a discount rate that is lower than the WACC.

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