Determine the cost of all sources of capital

Reference no: EM131478191

PART 1: CALCULATING THE COST OF CAPITAL

Your analysis of your client's financial position has been very helpful in enabling the firm to identify strengths and weakness, and make changes to capitalise on its strengths and tackle its weaknesses. Based on your advice, changes have been made and will be made to improve the firm's financial position and position it to take on new projects and expand into new markets.

It is now February 2022. Your client has identified a number of potential new projects that the firm could undertake, but isn't sure how to decide which ones to go ahead with. Your client has asked for your advice. You have initially explained to your client that the first thing to do is to work out the firm's Weighted Average Cost of Capital, because that is the minimum return required on new projects in order meet the cost of capital and maintain or increase the value of the firm. Your client has therefore provided the most recent set of financial statements, as at 31 December 2021 (see Part 3), and has asked you to calculate the firm's WACC based on the sources of capital shown in its most recent Balance Sheet.

Your task:

1. Determine the cost of all sources of capital (i.e. all non-current liabilities, ordinary shares and preference shares). (Note: Do not include Retained Earnings. Since all reserves, including retained earnings, belong to the owners of the ordinary shares, we assume that the market value of the ordinary shares includes the value of these reserves.)

2. Determine the market value of all sources of capital (excluding retained earnings).

3. Calculate the firm's Weighted Average Cost of Capital.

In order to carry out this task, you have asked for and received the following additional information from your client:

The interest rate on the Bank Loan is 11.4% p.a.

The interest rate on the Mortgage Loan is 9.4% p.a.

The corporate bonds are rated BBB-, have 7 years to maturity and pay a quarterly coupon at a rate of 7.9% p.a.

The ordinary shares have a beta of 1.35.

The preference shares pay a fixed annual dividend of 15 cents per share.

Shown below is a table of credit spreads for different credit ratings and terms to maturity, the yield on Australian Government Securities for various terms to maturity, and the market risk premium. To determine the cost of the corporate bonds, find the relevant credit spread (shown in basis points, where a basis point 1/100th of 1%) based on the bonds' credit rating and term to maturity, and add this to the risk-free rate that matches the term to maturity of the corporate bonds. You should use the yield on 10-year Government Securities to represent the risk-free rate in the Capital Asset Pricing Model.

Standard and Poor's Credit Spreads
Credit Rating	3-year	5-year	7-year
AAA	129	159	189
AA+	140	170	200
AA	151	181	211
AA-	162	192	222
A+	173	203	233
A	184	214	244
A-	195	225	255
BBB+	206	236	266
BBB	217	247	277
BBB-	228	258	288
BB+	239	269	299
BB	250	280	310
BB-	261	291	321
B+	272	302	332
B	283	313	343
B-	294	324	354
CCC+	305	335	365
CCC	316	346	376
CCC-	327	357	387
CC	338	368	398
C	349	379	409

PART 2: PROJECT EVALUATION

There is one particular project the firm is considering. Now that you have calculated the firm's cost of capital, you are in a position to use it to recommend to the client the acceptance or rejection of the project that is under consideration.

The project in question involves the acquisition of a new machine which will enable the firm to increase production of prefabricated homes. The firm has provided the information about this project, shown below.

Your task:

1. Determine the incremental free cash flows that would result from the acceptance of this project.

2. Calculate the NPV of the incremental free cash flows.

3. Provide the firm with your recommendation as to whether it should accept or reject this project.

Project information. (All values are in thousands of dollars.)

A feasibility study has been undertaken at a cost of $13, which has generated the following data.

The machine will have a useful working life of 4 years. It will cost $200 to purchase and install. This cost will be depreciated over the life of the project to a book value of zero using diminishing-value depreciation. The machine is expected to have a salvage value of $24, which will be received in Year 5.

The project will require an increase in net working capital of $16, which will be recovered in Year 5, after the machine is disposed of.

The new machine will generate increased revenue of $140 in its first year of operation. However, due to increased wear and tear, the output of the machine, and hence the level of additional revenue, in Years 2, 3 and 4, will decrease each year by 3% from the previous year.

Use of the new machine will require an additional $41 per year in wages. It will also incur additional maintenance costs of $11 in the first year. Because of additional wear and tear, this maintenance cost will then increase by $3 per year for the remaining life of the machine.

The machine will be installed in a building already owned by the firm. If this project does not go ahead, this building could be rented out for $15 per year.

Attachment:- Assignment Files.rar

Reference no: EM131478191

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Reviews

len1478191

4/29/2017 2:13:39 AM

Kindly provide your best quote if you can complete this assignment. Tasks, descriptions and assessment weightings- Determination of the cost of all sources of capital, Determination of the market value of all sources of capital and Calculation of the weighted average cost of capital. As this is a calculation and accounting exercise, marks will be deducted for errors made, in proportion to the seriousness of the error.

len1478191

4/29/2017 2:13:29 AM

You can create the workings in Word (or similar), or you can do the workings in Excel and then copy and paste them into the appendix. Do not take a photograph of handwritten calculations. Do not round off intermediate answers when making calculations. Either use a spreadsheet, or keep all intermediate answers in your calculator, or if you must write down an intermediate answer, use 6 decimal places. Word limit: There is no word limit. This is not applicable to calculations. Your labelling of your results doesn't require many words, but there should be a brief introduction so that the client knows what information your are providing to them. You should conclude by explaining to the client what the final number - the NPV - means, and why you have made the recommendation that you have.

len1478191

4/29/2017 2:13:22 AM

You should present your findings (i.e. the answers to each of the above three questions in part 2) in the main body of the report, and include all workings in an appendix. The incremental free cash flows should be shown in a table similar to the ones shown in the solutions to the seminar activities. You could create the table in Word (or similar), but that is prone to error. It is recommended that you construct the table in Excel, using the functionality of Excel to do the calculations, and then copy the table into the body of the report. The workings (e.g. calculation of depreciation, calculation of NPV) should be shown in an appendix.

len1478191

4/29/2017 2:13:11 AM

You should present your findings (i.e. the answers to each of the above three questions in part 1) in the main body of the report, and include all workings in an appendix. That way the reader can look at the detailed workings if they wish to. (But I am going to.) You can create the workings in Word (or similar), or you can do the workings in Excel and then copy and paste them into the appendix. Do not take a photograph of handwritten calculations. This is not acceptable for a business report or a University assignment. Do not round off intermediate answers when making calculations. Either use a spreadsheet, or keep all intermediate answers in your calculator, or if you must write down an intermediate answer, use 6 decimal places. Word limit: There is no word limit. This is not applicable to calculations. Your labelling of your results doesn't require many words, but there should be a brief introduction so that the client knows what information your are providing to them. You should conclude by explaining to the client what the final number - the WACC - means.

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