A unique hypothetical weighted average cost of capital (WACC) and the rate of return
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A unique hypothetical weighted average cost of capital (WACC) and the rate of return
Total shares outstanding 1,000000
Share price $ 40
Market value of long-term debt (bonds) $20,000,000
Risk-free rate (10-year Treasury) 2.0%
Cost of debt (rate of return on company bonds) 5.0%
Corporate tax rate of 20%
Investor risk premium 5.5%
Company’s Stock Beta 1.10
Determine the Market Value of Equity by multiplying the total number of shares outstanding times the current share price. In our example, the market value of our unique hypothetical company is 1,000,000*$40=40,000,000
Determine the Market Value of Debt –This step determines the value of the company's long-term debt on the balance sheet. $20, 000,000
Cost of equity of (2.0%+5.5*1.10) =8.05%
Calculate the Cost of Debt – The next step determines the cost of debt, which is assumed (5.0%) (The rate of return expected by the company’s long-term bondholders) (Brigham & Ehrhardt, 2011). There is an adjustment of the figure for the tax-deductibility of interest expense as 1.00 minus the company’s tax rate of (20%). The example results in a cost of debt equal to ((5.00%*1-.20)) = 4.00%
WACC = (R/V * Ke) + (D/V) * Kd * (1 – Tax Rate)
WACC= $40,000,000/$60,000,000 ($40,000,000+20,000,000=60,000,000) *8.05%+ (20,000,000/60,000,000 *5.00% (1.00-20%)
WACC= (66.7%*8.05%) + (33.33%*4.00%)
WACC= 6.70%
Recommend whether or not the company should expand, and defend your position
The company should expand because the rate of return is higher than WACC, so the investment is valid and reasonable. The company will be able to generate high returns from the amount of capital invested because the level of performance exceeds the cost of capital as estimated. WACC will help to design and implement incentive plans for compensation to test annual as well as long-term incentives. Unless the return performance of a company is more than the estimate of the cost of capital, the management should not approve the performance target of the return on investment (Higgins, Koski & Mitton, 2016).