Determining the Cost of Capital: Can One Size Fit All?

What is the correct capital structure and weighted average cost of capital for discounting the investment’s free cash flow?

As an amusement park operator, it is clear to assume that WAL’s intention of acquiring the wound-up company’s assets was to move and operate them at the new location. Therefore, transportation cost ($350,000) and the other costs to get them up and running ($400,000 and $500,000) should be capitalized as part of acquired asset ($4.25 million). By the lower of cost or market valuation system rule, $4.25 million will be recorded for the purchase price. In addition, 0.60 million valuation difference needs to be accounted for using appropriate ASPE recommendations. This capitalization approach will lead to the same effects as the above two approaches toward stakeholders.

The company will incur floatation since before tax cost of the new debt will be higher than 8%. It can be included in calculating the cost of debt but these costs are reduced for taxable issuers and therefore can be expensed over the life of the issue.

See Table 1: Expected non-operating cash flow when the project is terminated at year 4 = 165,880$

Should flotation costs be included in the component cost of debt calculation? Flotation costs are typically included in the component of debt calculation as a part of calculating the nominal rate of the debt’ cost. The costs related to the process of getting new securities. Flotation costs cover both the underwriting spread and the costs paid by the issuing company from the offering. Shown as a portion of gross proceeds, costs usually rise as risks associated with the issue rise, or the size of the offering decreases.

Star Appliance is looking to expand their product line and is considering three different projects: dishwashers, garbage disposals, and trash compactors. We want to determine which project would be worth doing by determining if they will add value to Star. Thus, the project(s) that will add the most value to Star Appliance will be worth pursuing. The current hurdle rate of 10% should be re-evaluated by finding the weighted average cost of capital (WACC). Then by forecasting the cash flows of each project and discounting them by the WACC to find the net present value, or by solving for the internal rate of return, we should be able to see which projects Star should undertake.

Two managers attending an executive education course attempt to develop a cost of capital estimate for a leading telecommunications company, Telus The two managers are somewhat confused about the costs of various sources of capital, the calculation of the overall cost of capital and the appropriate use of the hurdle rate

When new equity is to be raised, then there will be floatation cost. The net price will be $25-$2 the floatation cost = $23.

a) We calculated the total value of AirThread (before considering any synergies) by subtracting the value of the non-operating assets from the going concern value. This gave us a total value of $6237.85.

The senior management of Company A employ you to advise them on the cost of capital the company should use to calculate net present value and decide whether or not to undertake a new investment project. You may assume that the new project is comparable to the average of the company’s existing projects in all respects.

It is often questionable as to whether flotation costs are included in the calculation of a firms cost of debt. Flotation costs are the costs associated with the issuance of new securities. These costs should be included in this calculation. For debt, however, this value is usually ignored because it is very small and does not have a significant affect on the outcome of the calculation. Also, when

* We assume the cost of capital to be a stated annual rate to facilitate calculations;

Although, it is true that lower hurdle rates would translate into high growth projects, but including it in Manager’s compensation plan might lead to agency problem where managers may try to manipulate the hurdle rates in order to get the projects through and make money.

INPUT DATA: Amount Needed to Raise Flotation Costs Stock Offer Price Market Value/Book Value Ratio (Dollars in thousands) Assets Cash U.S. Treasuries Mortgage-backed Securities Municipal Bonds Government Agency Securities Total Cash & Securities Residential Mortgage Loans Consumer Loans Business Loans Total Loans Fixed Assets Total Assets Liabilities Passbook Savings Non-interest Checking N.O.W. Accounts Money Market Accounts Certificate of Deposits Total Savings Borrowed Money Other Liabilities Total Liabilities Capital Stock ($100 par value) Retained Earnings Total Equity Total Claims Loan Loss Reserve Allowable Risk Adjustment Weights: No default risk Low default risk Res. loans &

(Note: retained earnings information is irrelevant here) Part b. Total market value = debt + pref. equity + Common equity = 1,147,200 + 1,250,000 + 2,500,000 = $4,897,200