AFMP4
Syllabus B3cd. The Cost of CapitalAdvanced cost of capital

WACC calculated using ungeared Ke 2 / 2

Use when the company is financed entirely by equity

Illustration 1

Cow Co is an unlisted company producing milk and wants to be  listed on a stock exchange and be financed entirely by equity.

Cow Co’s closest competitor is Milk Co, a listed company which produces milk worldwide.

Milk Co:
MV debt = $500
MV equity = $200
Milk Co’s geared cost of equity is estimated at 12% and its pre-tax cost of debt is estimated at 5%.

Tax is 25%

Required
Calculate Cow Co's WACC.

  • Solution:

    As Cow Co. wants to be financed entirely by equity, we will use Milk Co's Ungeared Ke (includes only equity, NO debts) as WACC.

    Milk Co, ungeared Ke:
    Keg = Keu + (1 – t) (Keu – Kd) D/E
    12% = Keu + 0.75 x (Keu – 5%) x 500/200
    12% = Keu + 1.875Keu - 9.375%
    12% + 9.375% = Keu + 1.875Keu
    21.375% = 2.875Keu
    Keu = 7.43% (say 7%)

Exam standard example (extract)

Mlima Co is a private company involved in aluminium mining. 

Mlima Co is an unlisted company and wants to be listed on a stock exchange and be financed entirely by equity.

Mlima Co’s closest competitor is Ziwa Co, a listed company which mines metals worldwide. 

Mlima Co’s directors are of the opinion that after listing Mlima Co’s cost of capital should be based on Ziwa Co’s ungeared cost of equity. 

Ziwa Co’s geared cost of equity is estimated at 16•83% and its pre-tax cost of debt is estimated at 4•76%.

These costs are based on a capital structure comprising of 200 million shares, trading at $7 each, and $1,700 million 5% irredeemable bonds, trading at $105 per $100. 

Both Ziwa Co and Mlima Co pay tax at an annual rate of 25% on their taxable profits.

Required

Calculate Mlima Co's WACC.

Solution

Ziwa Co

MV debt = $1,700m x 1•05 = $1,785m
MV equity = 200m x $7 = $1,400m

Ziwa Co, ungeared Ke

Keg = Keu + (1 – t) (Keu – Kd) D/E

16.83% = Keu + 0.75 x (Keu – 4.76%) x 1,785/1,400
16.83% = Keu + 0.9563Keu - 4.55%
16.83% + 4.55% = Keu + 0.9563Keu
21.38% = 1.9563Keu
Keu = 10.93% (say 11%)