Question 3: Weighted Average Cost of Capital (WACC) (20 marks)

Blackgold Ltd. currently has $532 million of market value debt outstanding. Blackgold Ltds 8 per cent coupon bonds have a face value of $1,000 and pay coupons on a semi-annual basis. The bonds mature in 20 years and are currently priced at $1,330 per bond. The company also has on issue 3 million preference shares outstanding with a market price of $14 per share that offer an annual dividend of $1.40. Blackgold Ltd also has 20 million ordinary shares outstanding with a price of $22.00 per share. The companys share has a beta of 1.6, the risk-free rate is 3% per annum and the market risk premium is 5% per annum. The companys corporate tax rate is 30%.

1. Calculate the firms weighted average cost of capital (WACC). (12 marks)

(Please ensure that you show all working, you can insert a scan or photograph of handwritten workings if you wish).

2. Blackgold Ltd operates in different industry segments. The company has a new project in the oil pipeline segment and the company estimates that the projects beta is 1.3. Will the discount rate used to discount the oil pipeline projects incremental free cash flows be higher or lower or equal to the firms WACC? Justify your answer. (3 marks)

3. Fuelflow operates in the same industry segments as Blackgold, Fuelflow makes a new WACC estimate and under estimates its true WACC. Fuelflow uses its new WACC estimate as its benchmark discount rate when it discounts its new projects incremental cashflows. All Fuelflows new projects have conventional cashflows. What effect will the new under-estimated WACC have on Fuelflows market value? Explain your answer.

(5 marks)