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Discounted Cash Flows Model - WACC

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The Pauncefort Group is active in a number of different industrial sectors, particularly Engineering. Quentin plc is the group holding company. The Board of Directors of Quentin plc are actively considering a number of projects that might be undertaken by the company or one of its subsidiaries. As a matter of policy, the Board appraises the viability of projects using a discounted cash flow approach.

Quentin plc has 12 million ordinary shares of 50p each in issue out of an authorised ordinary share capital of 15 million. The company has recently paid a dividend of 11p per share on the ordinary shares, which are currently listed at 111p ex div. The dividend growth rate has recently been a little under 11% p.a., and this is expected to continue for the foreseeable future. Extracts from the group balance sheet are as follows:

Quentin plc
Ordinary shares 6,000
Share premium 4,920
Reserves 7,590
Minority interests 1,590
3% irredeemable debentures 4,000
6% redeemable debentures 5,000

Interest on the debentures is payable annually, and both of the current year's payments are impending. The current market prices for £100 nominal value stock are £33.50 and £105.50 for the 3% and 6% debentures, respectively (both values being cum interest). The 6% debentures are redeemable in ten years' time at a premium of 2.5%. The effective corporation tax rate for Quentin plc is 35%.

Calculate the weighted average cost of capital to be used by the company in appraising the viability of its projects, explaining and justifying the approach, and commenting on the results.

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Solution Summary

The solution examines a discounted cash flow model.

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A firm's long-term success depends upon the firm's investments earning a sufficient rate of return. This sufficient or minimum rate of return necessary for a firm to succeed is called the cost of capital.

The cost of capital can also be viewed as the minimum rate of return required keeping investors satisfied. Thus it is used to know the rate of return expected by the investors.

Cost of capital (WACC)=
(Cost of Equity x Proportion of equity from capital)+ (Cost of debt x Proportion of debt from capital)+ (Cost of Preference share x Proportion of preference share from capital).
Equity includes retained earnings and the cost of R/E is taken at cost of equity. Cost of equity capital is the opportunity ...

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