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a)Calculate the cost of capital for TLC. Ltd. on the assumption that investors can remove all unsystematic risk by diversification.
-Systematic risk of TLC Ltd’s equity is 0.80;
– risk free rate is 10%;
– expected rate of return is 15%;
– the sources of funds used by TLC Ltd and their respective market values:
Source of funds Market Value($m)
Debt(par value $100) 1
Equity 3
– Interest rate on debt is 11% paid annually. The debt which is due to mature in 8 years time, has a current market price of $111.
– The company tax rate is 30%.Answers that i have calculated:
WACC= E/V*RE+ D/V*RD(1-TC)RE= 0.14
RD= 0.09012
E/V = 3/4
D/V= 1/4
(1-TC) = (1-0.3)
WACC= 12.08%b) Under what assumptions is the cost of capital you have calculated for TLC Ltd in (a) appropriate for a proposed project?
Based on the answer i have calculated, may i know what assumptions to be made??
To use the WACC that you have calculated assumes that the new project has the same systematic risk as currently exists in the company, and also assumes that it is financed in such a way as to maintain the current gearing of the company.
For more on this you should watch my lecture on Chapter 18 of our Course Notes (“When (and when not) to use the WACC for investment appraisal”) – both the lecture and the Course Notes are free of charge.
One thing about your calculations. Because the debt is redeemable, it is not valid to say that the cost of debt = Kd(1-T). You need to calculate the IRR of the after tax flows. (See Chapter 17 of the Course Notes, and the lecture that goes with it.)
Yup, i calculated the IRR which results in 0.09012.
So based on the answers given as follows:
– The risk of the new project will be identical to the average risk of the existing company;
– the new project will not cause the company’s optimal capital structure to change;
– the systematic risk (Beta), the risk free rate and the expected return on the market portfolio will remain constant over the life of the project;
– the cost of new funds will remain the same as the existing costs.May i know how to justify them?
You may have calculated the IRR of the pre-tax flows, but you have then multiplied it by ( 1-T) to get the cost of debt. You can only do this when the debt is irredeemable. For redeemable debt you need the IRR of the after- tax flows (and then you do not multiply the answer by (1-T).
With regard to the assumptions, you cannot justify them without proving the theory yourself ( which is not in the syllabus).
If you mean justifying making the assumptions (which is a different question) then it is simply that without knowing (for example) the systematic risk of the new project, there is nothing else you could do.owhh.. i get it. so it shud be WACC= 3/4(0.14)+1/4(0.0631) = 12.08% [0.09012x(1-0.3)]=0.0631 right?
So, how do i make assumptions? I’ve watched your lecture videos though.
No – when the debt is redeemable you do not do that. Read again what I wrote in the first part of my last reply.
With regard to assumptions, if ever we appraise a project at the WACC we are automatically making the assumptions about risk and gearing that I mentioned before (otherwise appraising at the WACC would not be valid).
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