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ABC Ltd has decided to use the weighted average cost of capital (WACC) to discount the after-tax cash flows associated with project evaluation. You have

ABC Ltd has decided to use the weighted average cost of capital (WACC) to discount the after-tax cash flows associated with project evaluation. You have been given the task of determining the after-tax WACC of the firm. You are informed that ABC Ltd uses the following securities to fund its operation:

  • 40,000 individual bonds with 6%, 10-year $1,000 face value that were issued 4 years ago have 6 years remaining and offer a coupon that is paid half-yearly. The current market interest rate for these bonds is 7% per annum.
  • 2,500,000 ordinary shares, which recently paid a dividend of 55 cents. Dividends are expected to grow at 5% per annum perpetually. The current share price is $30.
  • Using the historical data, the covariance between the returns of ABC Ltd and the returns of S&P/ASX200 is found to be 0.0017 and the standard deviation of S&P/ASX 200 returns is 0.0419. The risk-free rate is currently 1.7% per annum, and the market risk premium is 6% per annum.
  • For the cost of equity calculation, ABC Ltd has decided to use the average of two values obtained from the constant growth model and the CAPM.
  • 1,000,000 preference shares, which pay an annual dividend of 50 cents. Each preference share trades at a market price of $10.
  • The company tax rate is 30%.

Required:

a) Compute the WACC. (15 marks)

b) Your company is considering an acquisition of Moon Ltd whose WACC is 11%. Your companys purchase of Moon Ltd will cost 120 million, and will generate cash flows that start at $10 million in Year 1 and then grow at 5% per year forever. The cost of environmental clean-up is expected to be $500,000 per year starting from Year 6 in perpetuity. What is the NPV of the acquisition? Should your company go ahead with the acquisition and why? (5 marks)

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