Weighted Average Cost of Capital

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Business Finance

Description

Scenario: You work for an investment banking firm and have been asked by management of Vestor Corporation (not real), a software development company, to calculate its weighted average cost of capital, to use in evaluating a new company investment. The firm is considering a new investment in a warehousing facility, which it believes will generate an internal rate of return of 11.5%. The market value of Vestor's capital structure is as follows:

Source of Capital

Market Value

Bonds

$10,000,000

Preferred Stock

$2,000,000

Common Stock

$8,000,000

To finance the investment, Vestor has issued 20 year bonds with a $1,000 par value, 6% coupon rate and at a market price of $950. Preferred stock paying a $2.50 annual dividend was sold for $25 per share. Common stock of Vestor is currently selling for $50 per share and has a Beta of 1.2. The firm's tax rate is 34%. The expected market return of the S&P 500 is 13% and the 10-Year Treasury note is currently yielding 3.5%.

Determine what discount rate (WACC) Vestor should use to evaluate the warehousing facility project.

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Explanation & Answer

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Weighted Average Cost of Capital
Weighted Average Cost of Capital (WACC) is the average rate of return a company expects to
compensate all its different investors with the weights representing the proportion of each source
of financing that is used. In evaluating projects funded by a combination of different sources of
finance, WACC is the appropriate discount rate to use in this case. The formula for calculating
WACC is given as follows:
WACC= WeKe + WdKd + WpKp
Where,
We, Wd, W...


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