Weekly tasks or assignments (Individual or Group Projects) will be due by Monday and late submissions will be assigned a late penalty in accordance with the late penalty policy found in the syllabus. NOTE: All submission posting times are based on midnight Central Time.

Respond to the following scenario with your thoughts, ideas, and comments. Be substantive and clear, and use research to reinforce your ideas.

Mary Francis has just returned to her office after attending preliminary discussions with investment bankers. Her last meeting regarding the intended capital structure of Apix went well, and she calls you into her office to discuss the next steps.

“We will need to determine the required return for our intended project so that we have a decision criteria defined for the project,” she says.

“Do you have the information I need to describe capital structure and to calculate the weighted average cost of capital (WACC)?” you ask.

“I do,” she smiles. “We can determine the target WACC for Apix Printing Inc., given these assumptions,” she says as she hands you a piece of paper that says the following:

• Weights of 40% debt and 60% common equity (no preferred equity)
• A 35% tax rate
• Cost of debt is 8%
• Beta of the company is 1.5
• Risk-free rate is 2%
• Return on the market is 11%

“Great,” you say. “Thanks.”

“Be sure to indicate how these costs of capital might be used to determine the feasibility of the capital project,” Mary says. “I want your recommendation about which is more appropriate to apply to project evaluation, too. Let me know what you think.”

“One more thing,” she says as she stands up to signal the end of the meeting. “You did a good job with the explanations that you provided Luke the other day. Would you have time to define marginal cost of capital for me so I can include it in my discussions with investors? You seem to have a knack for making things accessible to nonfinancial folks.”

“No problem,” you say. “I’m glad my explanations are so useful!”

For this assignment, complete the following:

• Describe capital structure.
• Determine the WACC given the above assumptions.
• Indicate how these might be useful to determine the feasibility of the capital project.
• Recommend which is more appropriate to apply to project evaluation.
• Define marginal cost of capital.

Please submit your assignment.

For assistance with your assignment, please use your text, Web resources, and all course materials.

U3IP

Deliverable Length: 750 – 1,000 words. Use Word. 150 Points Possible

In this exercise you need to describe capital structure of Apex, calculate the weighted average cost of capital (WACC) and define marginal cost of capital. You must indicate how these costs of capital might be used to determine the feasibility of the capital project.

Please show your work and the equations that you use to calculate the WACC.

Given:

Weights of 40% debt and 60% common equity (no preferred equity)

A 35% tax rate

Cost of debt is 8%

Beta of the company is 1.5

Risk-free rate is 2%

Return on the market is 11%

Organize your work under the following headings:

1. Describe capital structure.
2. Determine the WACC given the above assumptions.
3. Indicate how these, WACC and Capital Structure, might be useful to determine the feasibility of the capital project.
4. Define marginal cost of capital.
5. Recommend which is more appropriate to apply to project evaluation, the capital structure or the WACC.

See the discussion of WACC below.

U1I: INTELLIPATH

Complete your Intellipath by Sunday

Intellipath Unit: Introduction to Capital Budgeting/Investment Valuation

Points Possible: 125

Try to complete your Determine Knowledge by Wednesday.

If you have problems, flag the question in Intellipath.

If you have questions, DO NOT use the Intellipath message system. Email me. Try to include a screen shot of the question.

Your path will only consist of learning nodes that you need to work on and is individualized for you, so if you have difficulty with a question you must flag the question in Intellipath.

WACC

To calculate the WACC you first need to determine the cost of equity using the capital asset pricing model:

N.B. Use this equation.

Re = (Rf) + [B(Rm – Rf)]

Re = Cost of equity

Rf = Risk free rate

B =Beta

Rm = Return on the Market

Once you calculate Re then you can calculate the WACC.

WACC = [(weight of equity) x (cost of equity)] + [(Cost of Debt) x (Weight of Debt) x (1-tax rate)]

The first step is use the CAPM to come up with the cost of equity. Once you have that you can use the WACC formula since debt and its tax relationship is already provided you will weight the equity cost.

WACC is calculated by taking into account the relative weight of each component of a company’s capital structure. The calculation usually uses the market values of the components, rather than their book values, which may differ significantly. Components may include equity (both common and preferred), debt (straight, convertible, or exchangeable), warrants, options, pension liabilities, executive stock options, and government subsidies. More exotic sources of financing, such as convertible/callable bonds or convertible preferred stock, may also be included in a WACC calculation if they are present in significant amounts as the cost of these is usually different from plain vanilla financing methods. For a company with a complex capital structure, calculating WACC can be a time-consuming exercise.

To determine the value of each component it is assumed that the weight of a source of financing is simply its market value (rather than the book value, which may be significantly different) divided by the sum of the values of all the components. The easiest component to calculate is the market value of the equity of a publicly traded company, as this is simply the price per share multiplied by the number of outstanding shares. Likewise, the market value of preferred shares is easy to determine and is calculated by multiplying the cost per share by number of outstanding shares. The market value of a company’s debt is also easy to discover if a company has publicly traded bonds. However, many companies have debt in the form of bank loans, whose market value is not easily found. However, the market value of debt is often fairly close to the book value, at least for companies that have not experienced significant changes in credit rating. Thus, calculation of WACC typically uses the book value of any debt.

On the cost side, the cost of preferred shares is calculated by dividing the periodic payment by the price of the preferred shares. The cost of ordinary shares is typically determined using the capital asset pricing model. The cost of debt is usually the yield to maturity on the company’s publicly traded bonds, or the rates of interest charged by the banks on recent loans. The cost of debt can be cut further as a company can usually write off taxes on the interest it pays on the debt. Thus, the cost of debt is calculated as yield to maturity multiplied by (1 minus the tax rate).

The weighted average cost of capital (also known as WACC) is the result of the after-tax cost of bonds and loans, and the return required by preferred and common stockholders. Note here that in the case of debt, this cost should be after-tax. The key concern here is what the weights are and what they represent. The weights are simply the percentage of each capital source used for the project. There are two types of weights: the first ones are the book values, which can be obtained from the company’s financial statements. The second ones are the market values which are found by multiplying the market price of the security by the number of securities outstanding in the market. For instance, for equity, we will multiply the market value of each share by the number of shares outstanding in the market.

Consider the following example:

Assume that competing Del Monte has 2,000 bonds outstanding that sell in the market for $1,200 each. It also has outstanding 30,000 shares of preferred stock selling at $40 per share and 220,000 shares of common stock selling at $12 per share. The market value weights are as follows:

Capital Component

Price per Bond or Share

Number Outstanding

Total Market Value of Component

Estimated Cost of Each Source

Debt (bonds)

$1,200/bond

2,000

$1,200 X 2,000 = $2.4 million

5%

Preferred Stock

$40/share

30,000

$40 X 30,000 = $1.2 million

2%

Common Stock

$12/share

220,000

$12 X 220,000 = $2.64 million

6%

Total Market Value of Capital                                   $6,240,000

Next, we find the proportion or percentage of financing supplied by each component:

Debt = $2,400,000/$6,240,000=38.5%

Preferred Stock = $1,200,000//$6,240,000= 19.2%

Common Stock = $2,640,000/$6,240,000= 42.3%

Remember that the total is always 100%

Then, we multiply the weight by the cost of each source and add them up as follows:

WACC = (% of debt x after-tax cost of new debt) + (% of preferred stock x cost of preferred stock) + (% of common stock x cost of common stock)

WACC = (38.5% x 5%*) + (19.2% x 2%) + (42.3% x 6%) = 1.93% + 0.38% + 2.54% = 4.85%

*This is an after-tax cost

The most adequate method for obtaining the weighted average cost of capital is to use the market values, but these might not always be available, and therefore, we sometimes need to rely on book values. Why are market values more relevant than book values? The answer is simple. Book values reflect historical costs that might have changed since securities were issued. For instance, assume that Dole issued bonds three years ago. Of course, the required return for bonds then depended on a number of factors that have changed over time and, most probably, is not the return required by investors today.

There is a good tutorial located at: http://www.expectationsinvesting.com/tutorial8.shtml. You may review this tutorial for a step-by-step application as well.

Let us look at an example – assume the following:

Debt = $100 million 

Preferred stock = $50 million 

Common stock = $250 million

Then the total capital base = $400 million

The weight of debt = 100/400 = 25%.

The weight of Preferred stock = 50/400 = 12.5%

The weight of Common stock = 250/400 = 62.5%

Kd = 7%

Kp = 9%

Ke = 13%

What is the Weighted Average Cost of Capital?

WACC = (wd) * Kd + (wp) * Kp + (we) * Ke

WACC = (7%*.25) + (9%*.125) + (13%*.625) 

WACC = .0175 + .01125 + .08125 = .11 or 11%

Another example of WACC:

Assume newly formed Corporation ABC needs to raise $1 million in capital so it can buy office buildings and the equipment needed to conduct its business. The company issues and sells 6,000 shares of stock at $100 each to raise the first $600,000. Because shareholders expect a return of 6% on their investment, the cost of equity is 6%.

Corporation ABC then sells 400 bonds for $1,000 each to raise the other $400,000 in capital. The people who bought those bonds expect a 5% return, so ABC’s cost of debt is 5%.

Corporation ABC’s total market value is now ($600,000 equity + $400,000 debt) = $1 million and its corporate tax rate is 35%. Now we have all the ingredients to calculate Corporation ABC’s weighted average cost of capital (WACC).

WACC = (($600,000/$1,000,000) x .06) + [(($400,000/$1,000,000) x .05) * (1-0.35))] = 0.049 = 4.9%

Corporation ABC’s weighted average cost of capital is 4.9%.

This means for every $1 Corporation ABC raises from investors, it must pay its investors almost $0.05 in return.

Take the cost of each component of capital and multiply it by the weight of that component.

It is exactly like calculating your GPA.

Let’s say that debt has an after tax rate of 6%. In other words, for every dollar worth of debt we use, it will cost us 6%.

Let’s say that debt makes up 40% of our total funding. If we had, say $1,000,000 in total funding, $400,000 of it would be from debt.

So debt will contribute .06*.4 = .024 = 2.4% toward the total cost of capital.

Assume further that preferred equity has a cost of 7% and makes up 15% of our total funding.

Common equity makes up the rest (45%) and has a cost of 8%.

The weighted average cost of capital would be (debt x weight) + (preferred equity x weight) + (common equity x weight) = WACC

The weighted average cost of capital would be: .06*.4 + .07*.15 + .08*.45 = .0705 = 7.05%