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Weighted Average cost of Capital (WACC)

Summary of the balance sheet of XYZ below

Balance sheet of XYZ as at 31 December 2009 ('000)

Cash R10 Account payable R10
Accounts receivable 20 Acruals 10
Inventories 20 Short-term debt 5
Current assets R50 Current liabilities R 25
Net fixed assets 50 Long term debt 30
Preference shares 5
Ordinary equity
Ordinary shares 10
Retained earnings 30
Total(ordinary) equity 40
Total assets R100 Total liabilities and equity R100

The following facts are also given for XYZ:

(i) Short-term debt consists of bank loans that currently cost 10
percent, with interest payable quarterly. These loans are used to
finance receivables and inventories on a seasonal basis, so in
the off-season, bank loans are zero.

(ii) The long-term debt consists of 20-year, semi-annual payment
bonds with a coupon rate of 8 percent. Currently, these bonds
provide a yield to investors of Rd = 12 percent. If new bonds
were sold, they would yield investors 12 percent. If new bonds
were sold, they would yield investors 12 percent.

(iii) A XYZ preference share has a R100 par value, pays a
quarterly dividend of R2, and has a yield to investors of 11
percent. New preference shares would have to provide the same
yield to investors, and the company would incur a 5 percent
flotation cost to sell it.

(iv) The company has 4 million ordinary shares outstanding. The
shares have recently traded in a range of R17 to R23 with Po =
R20 as the most likely current price. Do = R1 and EPSo = R2.
ROE based on average equity was 24 percent in 2008, but
management expects to increase this return on equity to 30
percent; however, security analysts are not aware of
management's optimism in this regard.

(v) Beta coefficients for XYZ, as reported by security analysts,
range between 1,3 to 1,7. A Beta coefficient of 1,5 seems the
most likely value. The T-bill rate is 10 percent, and rM is
estimated by various brokerage houses to be in the range of
14,5 to 15,5 percent.

(vi) XYZ is in the 40 percent tax bracket.

(viii) XYZ's investment banker, predicts a decline in interest rates,
with rd falling to 10 percent and the T-bill rate to 8 percent,
although XYZ's investment banker acknowledges that an
increase in the expected inflation rate could lead to an increase
rather than a decrease in rates.

(ix) Growth in dividends, as estimated by the retention growth model
[g = b(r)] is 12 percent.
Based on the information provided, you are required to estimate the
company's Weighted Average cost of Capital (WACC). Assume that no
new equity will be issued. Your WACC estimate should be appropriate for
use in evaluating projects which are in the same risk class as the firm's
average assets now on books.

Solution Summary

The solution explains how to calculate the Weighted Average cost of Capital (WACC).