Question

McCormick & Company is considering a project that requires an initial investment of $24 million to build a new plant and purchase equipment. The investment will be depreciated as a modified accelerated cost recovery system (MACRS) seven-year class asset. The new plant will be built on some of the company's land, which has a current, after-tax market value of $4.3 million.

The company will produce bulk units at a cost of $130 each and will sell them for $420 each. There are annual fixed costs of $500,000. Unit sales are expected to be $150,000 each year for the next six years, at which time the project will be abandoned. At that time, the plant and equipment is expected to be worth $8 million (before tax) and the land is expected to be worth $5.4 million (after tax).

To supplement the production process, the company will need to purchase $1 million worth of inventory. That inventory will be depleted during the final year of the project. The company has $100 million of debt outstanding with a yield to maturity of 8 percent, and has $150 million of equity outstanding with a beta of 0.9. The expected market return is 13 percent, and the risk-free rate is 5 percent. The company's marginal tax rate is 40 percent.

What is the weighted average cost of capital (WACC)?

Answer 1

Total Capital value = Value of Debt + Value of Equity

=100+150

=250

Weight of Debt = Value of Debt/Total Capital Value

= 100/250

=0.4

Weight of Equity = Value of Equity/Total Capital Value

= 150/250

=0.6

Cost of equity

As per CAPM

Cost of equity = risk-free rate + beta * (expected return on the market - risk-free rate)

Cost of equity% = 5 + 0.9 * (13 - 5)

Cost of equity% = 12.2

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 8*(1-0.4)

= 4.8

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=4.8*0.4+12.2*0.6

WACC =9.24%