Question

(i) Boral currently has $400 million market value of debt outstanding. This debt was contracted five years ago at the rate of 4%. Boral can refinance 60% of the debt at 5% with the remaining 40% refinanced at 6.5%. The company also has an issue of 2 million preference shares outstanding with a market price of $20 per share. The preference shares offer an annual dividend of $1.5 per share. Boral also has 14 million ordinary shares outstanding with a price of $30.00 per share. Boral just paid a $1.2 ordinary dividend, and that dividend is expected to increase by 5 per cent per year forever. If the corporate tax rate is 40 per cent, calculate Boral’s weighted average cost of capital (WACC).

(ii) Discuss the limitations of WACC as a discount rate for evaluating new projects.

Answer 1

Wacc is weighted average cost of capital

Cost of equity can be calculated by dividend discount model

Ke = D1/p +g

Where D1 is dividend for year 1 = 1.2+5% = 1.26

P is price and g is growth

Ke= 1.26/30 + 0.05 = 9.2%

Cost of preferred stock = dividend/price

= 1.5/20 = 7.5%

Weighted average cost of debt is = 5×60% + 6.5×40% = 5.6%

Tax is 40%

After tax cost of debt = 5.6(1-0.4) = 3.36%

Weighted average cost of capital is

= (400×3.36+40×7.5+420×9.2)/860

= 6.40%

2) limitations of wacc is

1)wacc will not remain constant throughout the project it may change by circumstances

2)cost of debt is also changing with changing interest rates in future

3) wacc assumes no changes in risk profile which is false