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.

Now suppose that BigOil has a good credit rating, and you, as the company’s CFO, convinced the CEO and the Board of Directors to push up the company’s debt ratio to 50 percent. Given this new debt ratio and if the required rates of return on the company’s bond and equity are as found in (B) above, what is the company’s weighted average cost of capital? What would be the implication of using this WACC to evaluate the company’s investments?

Explanation / Answer

YTM of bonds==RATE(10,6%*1000,-807.47,1000)=9%
Pre-tax cost of debt=YTM=9%
After-tax cost of debt=pre-tax cost of debt*(1-tax rate)=9%*(1-35%)=5.85%

Cost of equity=risk free+beta*(market return-risk free)=3%+1.1*(11.2%-3%)=12.02%

Debt ratio is proportion of debt

WACC or cost of capital=proportion of debt* after tax cost of debt + proportion of equity*cost of equity=0.5*5.85%+0.5*12.02%=8.935%

As this is having higher debt ratio, using the initial cost of equity and return on bond would be incorrect because higher debt ratio means high risk and hence higher return is required for bonds and equity. In effect, we would be understating the cost of capital if we use the initial cost of equity and bond.

Nevertheless, with high debt ratio WACC has come down due to which company might start accepting projects which otherwise were not accepted in case of earlier high WACC

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