Question

AVERAGE COST OF CAPITAL

17. Given the following data, compute the weighted average cost of capital (WACC).

Components of capital structure                        After Tax Cost

Debt                 $65 million                                          6.5%

Preferred Stock     35 million                                         10.5%             

Common Equity    60 million                                        12.75%

Total                160 million

If the return on assets of the corporation is 13% on an annual basis, calculate its profitability and economic value added, EVA.

18. Provide an explanation or the rationale for the cost of capital (average or overall cost of capital, WACC) to an economic firm. That is, explain why the WACC should be used as the minimum required return.

Answer 1

WACC = 65/160 * 6.5% + 35/160 * 10.5% + 60/160 * 12.75% = 9.72%

RoA is given by Net Income / Total Assets. We have RoA and Total Assets, hence Net Income = 13% * 160 million = 20.8 million

EVA = Net Operating Profit after taxes - Inevsted Capital *WACC ; here since we do not have data to calculate the NOPAT, we take Net Income as proxy.

EVA = 20.8 - 160 * 9.72% = 5.25 million

The cost of capital is important for the firm since it allows it to eavluate and utlise the resources in the most efficient manner. Any economic unit is functioning under limited resource constraint, hence it should prioritise usage of capital and other resources to the best (highest NPV project) - in this endeavour the cost of capital sums up the opportunity cost and risk of underlying investment for the firm in a single number for them to easily sieve out the best alternative for them .