Model Answer
0 min readIntroduction
The cost of capital represents the minimum rate of return a company must earn on its investments to satisfy its investors. It’s a crucial metric in financial management, influencing investment decisions, valuation, and overall financial health. A company’s capital structure – the mix of debt and equity – significantly impacts its cost of capital. Calculating the overall cost of capital, also known as the Weighted Average Cost of Capital (WACC), is essential for evaluating the profitability of projects and ensuring shareholder value. This calculation helps determine if a company’s investments are generating sufficient returns to cover the costs of financing those investments.
Calculating the Overall Cost of Capital
The overall cost of capital, or WACC, is calculated as follows:
WACC = (Weight of Debt * Cost of Debt * (1 - Tax Rate)) + (Weight of Equity * Cost of Equity)
In this case, we are not given the tax rate, so we will assume it to be zero for the purpose of calculation. This simplifies the formula to:
WACC = (Weight of Debt * Cost of Debt) + (Weight of Equity * Cost of Equity)
Step 1: Calculate the Total Capital
Total Capital = Debentures + Equity
We need to determine the value of equity. We can infer this from the EBIT and Ke. However, without further information (like EPS or market price per share), we cannot directly calculate the market value of equity. We will assume that the equity value is such that the EBIT can generate a return of 20% (Ke). This is a simplification, but necessary given the limited information.
Let Equity Value = E
Total Capital = 30,00,000 + E
Step 2: Calculate the Cost of Debt (Kd)
The cost of debt is the interest rate paid on the debentures. In this case, the debentures have a 12% interest rate.
Kd = 12% = 0.12
Step 3: Calculate the Weight of Debt and Equity
We need to find the value of Equity (E) to calculate the weights. We know that EBIT is 10,00,000 and Ke is 20%. If we assume that the equity holders are earning 20% on their investment, then:
0.20 * E = 10,00,000 - (0.12 * 30,00,000)
0.20 * E = 10,00,000 - 3,60,000
0.20 * E = 6,40,000
E = 6,40,000 / 0.20
E = 32,00,000
Now we can calculate the total capital:
Total Capital = 30,00,000 + 32,00,000 = 62,00,000
Weight of Debt (Wd) = Debt / Total Capital = 30,00,000 / 62,00,000 = 0.4839
Weight of Equity (We) = Equity / Total Capital = 32,00,000 / 62,00,000 = 0.5161
Step 4: Calculate the WACC
WACC = (Wd * Kd) + (We * Ke)
WACC = (0.4839 * 0.12) + (0.5161 * 0.20)
WACC = 0.058068 + 0.10322
WACC = 0.161288
WACC = 16.13% (approximately)
Therefore, the overall cost of capital for A Ltd. is approximately 16.13%.
Conclusion
In conclusion, A Ltd.’s overall cost of capital is approximately 16.13%. This calculation is based on the provided information and the assumption of a zero tax rate. The WACC is a critical metric for evaluating investment opportunities and ensuring the company generates sufficient returns to satisfy its investors. A higher WACC indicates a greater risk or cost associated with financing, while a lower WACC suggests a more favorable financial position. Accurate determination of equity value is crucial for precise WACC calculation.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.