Sunday, 20 January 2013
“Weighted Average Cost of Capital”
Learning objectives:
To understand the important components of capital structure
To learn the concept of weighted average cost of capital
To understand concept of Pure Play method
Outcomes:
This assignment will enable the students:
1. To understand how change in capital structure affects weighted average cost of
capital
2. The use of pure Play Method in calculating systematic risk of a project
Case:
R&T Corporation is one of the leading pharmaceutical companies in Pakistan. R&T has
been severing this industry for the last 15 years contributing a considerable share in the
industry profits. The industry is at its growing stage, so companies have to upgrade
themselves to keep pace with arising challenges and to meet the arising needs of this
industry. Thus, the management of R & T has been giving emphasis on the Research and
Development area and at present, R & T has been able to maintain its position in the
industry successfully. Now, the management is considering diversifying its business and
planning to enter into beverage industry. For that purpose, a new division named as “Bev
–Dept.” is under consideration. Currently, R&T Corporation has 200,000 common shares
outstanding with the face value of Rs. 100 each. The Management has decided to
generate financing using three sources and details are as follows:
Market Value
Rs.
Book Value
Rs.
YTM t
Bond-A 3,800,000 3,750,000 15.0% 10 yrs.
Bond-B 2,800,000 2,250,000 12.5% 12 yrs.
Bond-C 1,500,000 1,050,000 14.0% 10 yrs.
R&T is currently paying divided at Rs. 8 per common share and this is expected to grow
at 6% in the foreseeable period. In the beverage industry, average equity beta is 1.2 and
debt-equity ratio is 40:60. It has been concluded after market analysis that new intended
project has a different risk level than that of existing industry.You are required to compute:
1. Equity beta for the new project by using Pure Play Method. (10 marks)
2. Cost of equity capital for the company after introducing new project if T-bills yield
is 10%, market required arte of return is 18%. (Use CAPM). (4 marks)
3. Cost of debt for new project (Based on book value of bonds). (12 marks)
4. Weighted average cost of capital for the company after issuing bonds (Based on
book value of bonds), if tax rate is 35%. (4 marks)
Note: Show complete formulas, calculation and working as they carry
marks
