After-tax cost of debt of 6% bank loan
The interest rate of the bank loan can be used as its before-tax cost of debt.
After-tax cost of debt of bank loan = 6 x (1 – 0·3) = 6 x 0·7 = 4·2% per year
Calculation of weighted average after-tax cost of capital (WACC)
Total value of company = 680m + 125·7m + 40m = $845·7m
After-tax WACC = ((680m x 10) + (125·7m x 4·9) + (40 x 4·2))/845·7 = 9·0 % per year
Examiner’s note: the after-tax cost of debt of the 8% bonds could have been calculated using linear interpolation, although
the result would be close to 4·9%.
(d) The weighted average cost of capital (WACC) is the average return required by current providers of finance. The WACC
therefore reflects the current risk of a company’s business operations (business risk) and way in which the company is
currently financed (financial risk). When the WACC is used as discount rate to appraise an investment project, an assumption
is being made that the project’s business risk and financial risk are the same as those currently faced by the investing
company. If this is not the case, a marginal cost of capital or a project-specific discount rate must be used to assess the
acceptability of an investment project.
The business risk of an investment project will be the same as current business operations if the project is an extension of
existing business operations, and if it is small in comparison with current business operations. If this is the case, existing
providers of finance will not change their current required rates of return. If these conditions are not met, a project-specific
discount rate should be calculated, for example by using the capital asset pricing model.
The financial risk of an investment project will be the same as the financial risk currently faced by a company if debt and
equity are raised in the same proportions as currently used, thus preserving the existing capital structure. If this is the case,
the current WACC can be used to appraise a new investment project. It may still be appropriate to use the current WACC as
a discount rate even when the incremental finance raised does not preserve the existing capital structure, providing that the
existing capital structure is preserved on an average basis over time via subsequent finance-raising decisions.
Where the capital structure is changed by finance raised for an investment project, it may be appropriate to use the marginal
cost of capital rather than the WACC.
