Determine The New Target Weighted Average Cost Of Capital

Determine the new target weighted average cost of capital for Felicia & Fred, given following assumptions: 

Felicia & Fred’s management has requested a revised financial analysis reflecting an increased leverage and a modified capital structure, with a corresponding impact on their weighted average cost of capital (WACC). The previous capital structure was relatively conservative, but now they aim for a 70% debt and 30% equity mix, with a higher cost of debt and increased company risk. This change necessitates recalculating the WACC to accurately evaluate project viability under new financial conditions.

The new assumptions provided include a debt-to-equity ratio with weights of 70% debt and 30% equity, a tax rate of 35%, a cost of debt of 10%, a company beta of 1.3, a risk-free rate of 2%, and a market return of 12%. Using the Capital Asset Pricing Model (CAPM), the cost of equity is computed, and combined with the cost of debt and tax effects, to derive the updated WACC.

Understanding WACC and its importance

The weighted average cost of capital (WACC) serves as a crucial discount rate in capital budgeting decisions, representing the average rate that a company must pay to finance its assets through debt and equity. It reflects both the cost of debt, which benefits from tax deductibility, and the return required by equity investors. A precise calculation of WACC ensures that project evaluations accurately mirror the firm’s capital structure and risk profile, thereby guiding optimal investment decisions.

Calculation of the new WACC using the provided assumptions

To estimate the new WACC, the following steps are executed:

  1. Calculate the cost of equity (Ke) using CAPM: Ke = Rf + β (Rm − Rf) = 2% + 1.3 (12% - 2%) = 2% + 1.3 (10%) = 2% + 13% = 15%
  2. Compute WACC: WACC = (wd)(Kd)(1 − Tc) + (We)(Ke)
  3. Where:
  • wd = weight of debt = 70% or 0.70
  • We = weight of equity = 30% or 0.30
  • Kd = cost of debt = 10%
  • Ke = cost of equity = 15%
  • Tc = tax rate = 35%

Substituting the values:

WACC = (0.70)(10%)(1 − 0.35) + (0.30)(15%) = 0.70 × 10% × 0.65 + 0.30 × 15% = 0.70 × 6.5% + 4.5% = 4.55% + 4.5% = 9.05%

Thus, the revised weighted average cost of capital is approximately 9.05%.

Implications for project evaluation

This lower WACC, due to the increased debt and associated tax shield benefits, indicates that the firm can evaluate projects with a slightly reduced hurdle rate. This adjustment is expected to make the project more appealing financially, possibly increasing the likelihood of approval for ventures similar to the crystal jewelry project. However, the higher leverage also elevates financial risk, which must be considered when assessing project cash flows and overall corporate risk profile.

Conclusion

The recalculated WACC at approximately 9.05% reflects the firm’s new capital structure emphasizing higher leverage. This rate will serve as the discount rate in subsequent project analyses, influencing the net present value (NPV) and internal rate of return (IRR) calculations. Understanding these financial metrics in light of the new WACC provides a sound basis for informed investment decisions aligned with Felicia & Fred’s strategic financial goals.

References

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