Task 2

Capital Structure and Weighted Average Cost of Capital:

In this task, we are examining the current capital structure of BEB and determine the WACC of the company. Assume that BEBs tax rate is 36%.

To compute the WACC you must first find the after-tax cost of debt, the cost of equity, and the proportions of debt and equity in the firm. You can assume that the cost of debt before tax is 7.5% for the firm. Please clearly show how you derive each of these values:

The after-tax cost of debt =

Cost of equity = (from your previous task)

Proportions of debt and equity in the firm (from the balance sheet) =

How do we compute the WACC in this circumstance? Why do we need to be concerned with the WACC?

Any insights into the capital structure of BEB ?

Concept Check: Capital structure for a public company consists of both debt and equity. We must take into account the ability to write off interest payments in the calculation of our cost of debt which results in an after-tax cost of debt being used in our WACC calculation.

The weighted average cost of capital is the weighted average of the cost of equity and the after-tax cost of debt. Another way of looking at this is by computing the effect of the capital structure on expected returns by investors.

WACC= (S/(B+S) x Rs) + (B/(B+S) x R_B x (1 t_c))

Where

S = value of equity

B = value of debt

Rs = cost of equity

After tax cost of debt: R_B x (1 t_c )

Helpful Hint: One thing to bring up here is WACC is needed to determine risk on several levels. To determine risk we need to remember the following items:

Risk is a deviation from expectations.

We need to set expectations for our investments based on risk and return. Higher risk = higher return.

Capital is obtained from the marketplace in two forms; equity and debt. This is the capital structure of a corporation and impacts the profits of a company depending on how this is managed.

We use our cost of capital to discount any cash flows from new investments (NPV and IRR analysis).

If the cost of capital rises then our risk rises and the projects we undertake to increase sales and return to our investors are reduced.

If debt rises then our obligation to make payments on interest increases and profits can decrease if sales do not increase rapidly enough.

If risk increases our beta will increase to show the increase in risk. This will increase our required rate of return to stockholders (CAPM) and thus increase our required rate of return we must use in discounting future cash flows.

Task 3

To illustrate and further support our strategic financial planning systems we need to show the CFO and management team an example of the application of the previously constructed WACC. The CFO thinks that showing management how we can validate and choose projects based on expected returns developed from the WACC will help reduce the risk of our investors capital thus lowering the required rate of return we would have to provide to those investors. If we lower our expected return we can then do more projects and grow at a faster rate.

He has asked your team to evaluate the following project:

Capital investment: BEB is planning the construction of a new loading ramp for its single mill. The initial cost of the investment is $600,000, followed by an investment of $200,000 10 years later and another investment of $200,000 20 years later and finally an investment of $1,000,000 for environmental cleanup at the end of the project 30 years from now. Efficiencies from the new ramp are expected to reduce costs by $50,000 per year (at the end of every year) for the life of the plant, which is currently estimated at 30 years (savings of $50,000 a year from 30 years). These savings can be assumed to be reinvested at a rate of 9% pa. What is the NPV of the project if BEB has a required rate of return of 7%? What is the MIRR of the project if the investing return rates (with the loading ramp used as collateral) for a period of 10 years is 6% pa and the term structure of investing return rates for Y years (Y > 15) is 6% + 0.0183*(1 - (1/(Y-9)) pa? You should use these investing return rates to discount back (to the present) the future investments that the loading ramp needs.

Concept Check: We need to adjust cash flows to account for things like inflation, our cost of capital, and opportunity costs. Simply looking at cash flow not adjusted for some of these costs will lead to taking on projects which are not adding to the value of the organization.

Helpful Hint: The first step in conducting an NPV analysis is to include all the relevant cash flows. This includes savings from taxes and any expenses directly related to the venture. We reject any project with a negative NPV.