Essay on Finance 100 - Hydrotech Case Study

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L.Spight
FIN100 – Week 10
Integrative Case Study
Due – 9/5/10

Case Information:
You work for HydroTech, a large manufacturer of high pressure industrial water pumps. The firm specializes in natural disaster services, ranging from pumps that draw water from lakes, ponds, and streams in drought stricken area to pumps that remove high water volumes in flooded area. You report directly to the CFO. Your boss has asked you to calculate HydroTech’s WAAC in preparation for an executive retreat. Too bad, you are not invited, as water pumps and skiing are on the agenda in Sun Valley, Idaho. At least you have an analyst on hand to gather the following required information:

1. The risk-free rate of interest, in this case, the yield
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3. Calculate the cost of equity capital using the CAPM, assuming a market risk premium of 5%.

Using CAPM: Risk Free Rate = 6%; Market Risk Premium = 5%; Beta = 1.2

Cost of Equity = Risk Free Rate + Equity Beta * Market Risk Premium
Cost of Equity = 6% + 1.2 * 5%
Cost of Equity = 0.06 + 1.2 * 0.05
Cost of Equity = .12
Cost of Equity = 12%

HydroTech’s cost of equity using CAPM is 12%.

4. Using a tax rate of 35%, calculate HydroTech’s effective cost of debt capital.

Cost of Debt = 7%; Tax Rate = 35%

Effective cost of debt capital = Cost of debt * (1 - tax rate)
Effective Cost of Debt Capital = 7% * (1 – 35%)
Effective Cost of Debt Capital = 0.07 * (1 – 0.35)
Effective Cost of Debt Capital = 0.07 * (0.65)
Effective Cost of Debt Capital = 0.0455
Effective Cost of Debt Capital = 4.55%

HydroTech’s Cost of Debt Capital is 4.55%.

5. Calculate HydroTech’s WACC

Weight of Equity = 71%; Equity Cost of Capital = 12%; Weight of Debt = 29%; Debt Cost of Capital = 4.55%

WACC = (Weight of Equity * Equity Cost of Capital) + (Weight of Debt * Debt Cost of Capital)
WACC = (71% * 12%) + (29% * 4.55%)
WACC = (0.71 * 0.12) + (0.29 * 0.0455)
WACC = 0.0852 + 0.013195
WACC = 0.098395
WACC = 9.8395% HydroTech’s WACC is 9.8395%.

6. When is it appropriate to use this WACC to evaluate a new project?

WACC is the weighted average cost of capital and provides firms with the idea of the proportion of debt

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