Determine The Appropriate Weighted Average Cost Of Capital ✓ Solved

Determine the appropriate weighted average cost of capital (WACC) for Vestor Corporation to evaluate its warehousing project and assess its investment decision

This assignment requires calculating the weighted average cost of capital (WACC) for Vestor Corporation based on its capital structure and market data. The purpose is to identify the appropriate discount rate for evaluating a new warehousing project expected to yield an IRR of 11.5%. This assessment will include detailed step-by-step calculations, including cost of debt, cost of preferred stock, and cost of equity, all incorporated into the WACC formula. Additionally, an analysis will be provided on whether Vestor should proceed with the investment based on the comparison of the project's IRR to the calculated WACC. The report should be approximately 400 words, include all calculation steps, and utilize Word tables for clarity. Proper justification for the chosen discount rate will be articulated to ensure transparent decision-making. The final evaluation will help determine if the project exceeds the firm’s required rate of return and supports profitable investment.

Sample Paper For Above instruction

Introduction

In investment decision-making, selecting an appropriate discount rate is critical for assessing the viability of new projects. The weighted average cost of capital (WACC) serves as a benchmark that reflects the firm's average cost of raising funds from equity and debt sources. This paper calculates the WACC for Vestor Corporation to evaluate a proposed warehousing facility expected to generate an internal rate of return (IRR) of 11.5%. By comparing this IRR to the WACC, the decision to proceed with the project can be justified or reconsidered.

Calculating Cost of Debt

Vestor's bonds have a face value of $1,000, a coupon rate of 6%, and are currently priced at $950. They mature in 20 years. To determine the cost of debt (after-tax), we first calculate the yield to maturity (YTM) using the following formula approximation:

Using a financial calculator or iterative approach, the approximate YTM is calculated as:

YTM ≈ [Coupon Payment + (Face Value - Price) / Years] / [(Face Value + Price) / 2]

YTM ≈ [60 + (1,000 - 950) / 20] / [(1,000 + 950) / 2] ≈ (60 + 2.5) / 975 ≈ 62.5 / 975 ≈ 0.0641 or 6.41%

Adjusting for the after-tax cost:

Cost of debt after tax = YTM × (1 - Tax rate) = 6.41% × (1 - 0.34) ≈ 6.41% × 0.66 ≈ 4.23%

Calculating Cost of Preferred Stock

The preferred stock pays a $2.50 dividend and was issued at $25 per share. The cost of preferred stock is:

k_ps = Dividend / Market price = $2.50 / $25 = 10%

Calculating Cost of Equity

The company's beta is 1.2, the risk-free rate (10-Year Treasury) is 3.5%, and the expected market return is 13%. Using the Capital Asset Pricing Model (CAPM):

k_e = Risk-free rate + Beta × (Market return - Risk-free rate)

k_e = 3.5% + 1.2 × (13% - 3.5%) = 3.5% + 1.2 × 9.5% = 3.5% + 11.4% = 14.9%

Calculating the WACC

The total market value of capital is:

• Bonds: $10,000,000
• Preferred Stock: $2,000,000
• Common Stock: $8,000,000

Total capital = $20,000,000

Weights are:

• W_debt = $10M / $20M = 0.5
• W_ps = $2M / $20M = 0.1
• W_e = $8M / $20M = 0.4

The WACC formula:

WACC = (W_debt × Cost of debt) + (W_ps × Cost of preferred stock) + (W_e × Cost of equity)

WACC = 0.5 × 4.23% + 0.1 × 10% + 0.4 × 14.9% ≈ 2.115% + 1% + 5.96% ≈ 9.07%

Investment Viability Assessment

The warehousing project has an expected IRR of 11.5%, which exceeds the calculated WACC of approximately 9.07%. This indicates that the project’s return is higher than the firm’s average cost of capital, suggesting that it would add value to Vestor Corporation. Therefore, it is financially prudent for Vestor to proceed with the investment.

In conclusion, the WACC provides an appropriate discount rate for evaluating the project, and since the IRR exceeds this rate, the investment is favorable from a financial perspective. The detailed calculations support this decision and demonstrate adherence to sound financial analysis principles.

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