PART 4: 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 11.6% p.a.

The interest rate on the Mortgage Loan is 9.3% p.a.

These can be taken to be the cost of these loans, and the values on the Balance Sheet can be presumed to be the market values.

Note: If you cannot see interest rates for the bank loan and mortgage loan on the above lines, you may need to view this spreadsheet on a PC.

The corporate bonds are rated B-, have 3 years to maturity and pay a semi-annual coupon at a rate of 6.5% p.a.

The ordinary shares have a beta of 1.23.

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.