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Homework answers / question archive / Calculating Project WACC Ranks Engineering, a civil engineering firm that has historically gotten most of its revenues from the planning and construction of public works projects, is considering starting a new division that will submit architectural designs for private engineering projects, such as designing shopping malls
Calculating Project WACC Ranks Engineering, a civil engineering firm that has historically gotten most of its revenues from the planning and construction of public works projects, is considering starting a new division that will submit architectural designs for private engineering projects, such as designing shopping malls. Adding the new division is expected to increase the firm's EBIT from $8 million to $10 million. While the civil engineering industry has a fairly low beta of 0.65, the private design market is a bit riskier, and Ranks has commissioned a study that shows that the average beta in that industry is approximately 1.3. Rank's capital structure currently consists of 1 million outstanding shares of common stock, selling for $37 per share, and a $ 15 million bond issue, selling at 98 percent of par. The expected market risk premium is 8 percent, and the current risk-free rate is 5.7 percent. The bonds pay an 8 percent annual coupon and mature in 10 years, and Ranks expects to be able to take full advantage of the interest tax shields on debt. If the new division will be funded with 70 percent equity and 30 percent debt, what should be the WACC for this new division? Answer
The rise in EBIT from $8 million to $10 million will be taxed at the 21 percent corporate tax rate, so the appropriate computation of the division's WACC will be WACC = = 0.70 X 0.1610 + 0.30 X 0.0830 x (1 – 0.34) 0.1291, or 12.91% =
WACC=(E/V)*ke+(D/V)*kd*(1-tax rate)
where E/V=weight of equity to firm value=.7 ; D=weight of debt to firm value=.3 ;
ke=cost of equity= risk free rate+beta*market risk premium
ke=5.7+1.3*8=16.1% ------ beta =1.3 (beta of the new industry should be taken and not the old industry)
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kd=cost of debt=YTM of the bond= rate(n,c,-pv,fv)
where n=no of years to maturity=10 years ; c=coupon rate=8%*1000=80;
pv=price=98% of par=.98*1000=98 ; fv=par value=1000;
kd=rate(10,80,-980,1000)=8.3% ------formula used in excel to calculate the ytm
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WACC= .7*16.1+.3*8.3*(1-.21) =13.237%
if tax rate is considered 34%; WACC= 12.91%
