# FIN 370 Weighted Average Cost of Capital Week 4

Purpose of Assignment

Students should understand the mechanics in calculating a company’s weighted average cost of capital using the capital asset pricing model (CAPM) and its use in making financial investments.

Assignment Steps

Resources: Tutorial help on Excel® and Word functions can be found on the Microsoft®Office website. There are also additional tutorials via the web that offer support for office products.

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 \$10,000,000 \$2,000,000 \$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.

Assess whether Vestor should make the warehouse investment.

Prepare your analysis in a minimum of 700 words in Microsoft® Word.

Use Microsoft® Word tables in the presentation if you choose.

Show all calculations and analysis in the presentation.

Format your assignment consistent with APA guidelines.

Click the Assignment Files tab to submit your assignment.

Introduction

The weightedaverage cost of capital(WACC) is animportant tool for evaluatingthefinancialimpact ofpotential projects.In this paper,we willcompletinganevaluation ofascenario usingthefollowinginformation from theUniversityof PhoenixFIN/370Week 4WeightedAverage Costof Capitalproject.

“Youwork for an investment bankingfirm and havebeen askedbymanagement ofVestorCorporation (notreal), a software developmentcompany,to calculate its weightedaverage cost ofcapital,to usein evaluatinganewcompanyinvestment. The firm is consideringanew investment in awarehousingfacility, which it believeswillgenerateaninternalrate of return of11.5%.Themarketvalue of Vestor’scapitalstructure isasfollows:

Source ofCapital Market Value \$10,000,000 \$2,000,000 \$8,000,000

Tofinance theinvestment, Vestor hasissued 20yearbonds with a\$1,000par value,6% coupon rate andat a market priceof\$950. Preferredstock payinga

\$2.50 annualdividend was sold for \$25 per share.Common stock of Vestor iscurrentlysellingfor \$50per share andhasaBetaof1.2. The firm’staxrateis34%.The expected market return oftheS&P 500 is 13% and the 10-YearTreasurynoteis currentlyyielding3.5%”.

# CapitalAssetPricingModel

The capital asset pricing model(CAPM) is animportanttool to use when dealing withriskyinvestments.The CAPM is used to find the required rateof returnthatshould be expectedon the inherentrisk ofthe asset(InvestigatingAnswers,2017).Calculating the CAPM is basedon three factors: (a)therate of returnfor theriskfree security,(b) theexpectedmarketrate ofreturn,and (c)thebetaofthe asset(InvestigatingAnswers,2017).To solve for CAPM, therateof return forthe riskfreesecurityplus the beta ofthe assetmultipliedbytheexpectedrate ofreturn minus the rate of returnfor theriskfree security(InvestigatingAnswers,2017). Whencalculated, thefair priceofthe investment is revealed to be14.90%(AppendixA).

# Vestor CorporationInvestment Advice

Asaninvestment bankingfirm wehave beenasked byVestor Corporationto assesswhether ornot Vestorshould invest in a new capitalinvestmentthat is a new warehouse facilitywhich theybelievewillgenerate aninternalrate of return of 11.5%.

In orderto appropriatelyanswer whether ornot Vestor Corporation should make thisinvestmentwe must firstdetermine iftheInternalRate of Return(IRR) isgreater than theWeightedAverage Costof Capital(WACC).IftheIRR isgreater than theWACC thencashflow increaseswhichadds to shareholdersequityand the investment should be made.

In lookingat a total snapshot ofthe calculations that were performed, provided below, the11.5%IRR is better thanthe9.10%WACC so Vestor Corporation should make the warehouseinvestment.Furthermore,since companies havelimited investmentcapitaland usuallyhavemultiple projects to consider, theyneed to rankprojects.Projectswith the highestIRR should beconsidered first for funding.

# AssessWhether VestorShouldMake the Warehouse Investment

The WACC is the minimumreturn acompanyneeds to earn to satisfyall its investors,includingstockholder, bond holder,andpreferredstockholder (Ross, 2015). On the hand, theIRR is the discountrate usedin capital budgetingthatmakes the netpresentvalue (NPV) of allcashflows(bothinflowand outflow) from aproject equal to zero(Folger,2017).VestorCorporationIRR is expected to be11.5% andaccordingto calculation theWACC is expected tobe 9.10%.Ingeneral, theIRRmethodindicates that a project whoseIRR is greater than orequalto the firm’scost ofcapital should be accepted, and a project whoseIRR is lessthan the firm’scost of capital should berejected(“What’s the DifferenceBetweenWeighted Average Cost ofCapital(WACC) AndInternalRate ofReturn (IRR)”,2017).Since,VestorIRR is projected tobe higher than its WACC it is safe thatinvestment in the warehouse will beof benefit forthecompany.After allfuturecost of fundsVestor Corporation is expected to make a2.4%profit.

Thereare so manyareasto look atwhendeterminingifit is worth theinvestment ifyou havetherightinformationandcalculations. Acompanywill need to look atall options to make sure thisis the rightone.As the informationsays this wouldmake sense togoaheadwith this projectbecause in theend aprofit of2.4% will be made.

# Conclusion

ThroughcalculatingVestor Corporation’sweightedaverage cost ofcapitalusingthecapitalasset pricingmodel (CAPM) we wereableto effectivelyevaluate the proposedwarehouse investment. Understandingthefinancial components ofacompanyand the overallimpact of investments is vital to a company’s future success. The overall Security Market Line or SML for short is also very good here which is ideal for a worthwhile investment. The CAPM is what shows the positive correlation between risk and reward which in the end is what SML is all about. This is honestly all the more reason why Vestor Corporation should go through with this investment, because it all not only pans out but from an investment standpoint it is almost a sure thing.

AppendixA:CapitalAssetPricingModelThe CAPM formulais: ra= rrf+Ba(rm-rrf)

rrf=therateof return forthe riskfree security.rm=the expectedmarketrate of return.

Ba=thebeta oftheasset

Thusgivingthe Vestorequation of:ra=.035 +1.2 (.13-.035)

ra=14.90%

Thisindicatesthat thefair price ofthe investmentshould be14.90%

Bondreturncalculation should bethe calculation to determine the discountrate (WACC) thatVestor should useto evaluate thewarehousingfacilityproject.

N=20,Pv=-950,Fv=1000,Pmt=60

UsingcptandI/YI/Y=6.45%

Cost of debt = (1 – taxrate) =1 -34%=.666.45%x.66 =4.26%

Prefer stockreturn=25/2.5=10%Common stockrequiredreturn

Requiredreturn=risk freerate +beta ×marketriskpremiumRequiredreturn=3.5% +1.2×9.5

Requiredreturn=14.9%

WACC = (E / V) xRe+ (D / V) xRd x(1 – Tc)

WACC=6.45× (1-.35) ×1000000/2000000 +10×200000/2000000+14.9×800000/2000000WACC=9.10%

Vector shouldgoahead and make the investment sinceIRR(11.5%) is more than WACC(9.10%).

Maturity 20
CurrentMarketPrice 950.00
Par Value 1,000.00%
Coupon Rate 6.00%
Annual Coupon Payment 60.00
Pre-TaxCost of Debt 6.45%
After TaxCost of Debt 4.26%
PreferredDividend 2.50
MarketPrice of PreferredStock 25.00
Cost of PreferredStock 10.00%
MarketReturn 13.00%
Risk Free Rate 3.50%
Market Risk Premium 9.50%
Beta ofP&G 1.2
Cost ofCommon Stocks(Equity) 14.90%
Sources MarketValue Weight Cost ofFund Tax Return After TaxCost ofFund WeightedAverageCost
Bonds 10,000,000 50.00% 6.45% 34.0% 4.26% 2.13%
PreferredStock 20,000,000 10.00% 10.00%     1.00%
Common Stock 80,000,000 40.00% 14.90%     5.97%
WACC           9.10%

# References

Folger,J.(2017).What’sthe difference between weightedaveragecost of capital(WACC) andinternalrate of return(IRR).Retrievedfrom:http://www.investopedia.com/ask/answers/062714/whats-difference-between-weighted-average-cost-capital-wacc-and-internal-rate-return-irr.asp