Index Plus Investments (IPI) Weighted Average Cost of Capital Index Plus Investm
ID: 2646925 • Letter: I
Question
Index Plus Investments (IPI) Weighted Average Cost of Capital Index Plus Investments (IPI) is considering a major expansion program that has been proposed by the company's IT Department. Before proceeding with the expansion, the company must estimate its cost of capital. Suppose that you are an assistant to Jerry Lehman, the Financial Vice President, and that he has asked you to calculate: IPI's Weighted Average Cost of Capital: The Rate of Return (aka hurdle rate) that the IT investments must provide: Fortunately Jerry hands you a sheet of paper with some potentially useful information on it. It's reproduced below. The firm's tax rate is 40%. The current price of IPrs 12% coupon, annual payment non-callable bonds with 15 years remaining to maturity is $1,253.72. IPI does not use short-term interest bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost. The current price of the firm's 10%. $100 par value, annual dividend preferred stock is $121.10. IPI's common stock is currently selling for $50.00 per share. Its last dividend (D0) was $4.19. and dividends are expected to grow at an annual rate of 5% In the foreseeable future. IPI's beta Is 1.2, the yield on T-Bonds is 7% and the market risk premium is estimated to be 6%. For the bond-yield plus risk premium approach, the firm uses a risk premium of 4%. IPI's target capital structure is 30% debt. 10% preferred stock and 60% common stock.Explanation / Answer
Part A
The average weighted cost of capital is the total cost of company's total capital sources.
These include common stock, preferred stock, bonds, and any other long term debt.
WACC can be calculated by the following formula =
WACC = (E/V * Re) + [(D/V * Rd)*(1-TC)]
Where, E = market value of the firm'e equity
D = Market value of the firm's debt
Re = Cost of equity
Rd = cost of debt
V = E+D
E/V = Percentage of financing that is equity
D/V = Percentage of financing the debt
TC is the corporate tax rate which is associated with the debt capital
= 50 / 1424.72 = .04
WACC = 0.08 * 0.10 + 0.04 * 0.06 + [(0.88 * 0.12) (1-0.4)]
= .008 + .0024 + .06336 = .07376 or 7.376%
Therefore WACC = 7.376%
Part 2 :
Required rate of return can be calulated by the following formula :
Yield on T bond + [ market beta * ( Expected growth - Yield on T bond )]
Yield on T bond = 7%
Expected growth = 5%
Market beta = 1.2
Putting the value in formula = 0.07 + [ 1.2 * (.05 - .07)]
= 0.07 + [ 1.2 * -.02]
= 0.07 + - .024
= 0.046 = 4.6%
Therefore required rate of return = 4.6%
Type of capital Market Price of capital Cost of capital Weight assigned = Market price of the capital / total market price of the capital Common stock $50 6%= 50 / 1424.72 = .04
Preferred stock $121 10% = 121/ 1424.72 = .08 Debt $1253.72 12% = 1253.72 / 1424.72 = .88 Total V = $1424.72 = 1