Major sources of funding available to companies include bond financing, preferred stock, new common stock, and retained earnings. Following the case scenario provided, the Vestor Corporation has employed bond, common stock and preferred stock financing to cover the funding requirements of the company’s assets.
Bond financing represents debt liabilities and has distinct advantages of using. First of all, bondholders do not share voting rights and have no rights over the company’s excess profits. Interest on debts is tax deductible, as well as costs of debt liabilities are usually lower than for common stock. On the other hand, debt financing is characterized by fixed charges, fixed maturity and restrictive covenants limiting flexibility of the company’s operations. Furthermore, debt increases business risk of the company, thereby increasing the cost of both debt and equity financing (Ehrhardt & Brigham, 2016; Fernandez, 2002).
The Vestor Corporation has issued bonds in the total amount of $10,000,000 (50% of the project funding requirements). To determine the cost of debt for the Vestor Corporation, yield on the company’s existing debt will be used. Following the case scenario provided, the company “has issued 20 years bonds with a $1,000 par value, 6% coupon rate and at a market price of $950”. The yield on the issued bonds can be found by equating the present value of coupon payments (annuity) and maturity value to the current market price of the bond:
$950 = $60 * ((1 – (1 / (1 + r) ^ 20) / r) + $1000/ ((1+r) ^ 20)
The equation has been solved by using the Excel Solver add-in, the obtained discount rate equals to 6.4521%. Therefore, the company’s cost of debt amounts to 6.4521%.
Another type of funding employed by the Vestor Corporation is the preferred stocks, issued in the amount $2,000,000 (10% of the project funding requirements). Preferred stock are mostly cumulative and pay a fixed amount of dividends. Advantages of these type of funding are that there is no maturity date and missed payment can be repaid later. Preferred stocks also avoid dilution of common equity and control rights of the shareholders. On the other hand, dividends of preferred stocks are not tax deductible, therefore there is no effect of tax shield in using this type of financing (Ehrhardt & Brigham, 2016; Fernandez, 2002).
Following the case scenario provided, the company has issued “preferred stock paying a $2.50 annual dividend” for the price of $25 per share. To determine the cost of preferred stock financing, the annual dividends should be divided by the market share price (no flotation costs were incurred following the case scenario): $2.50 / $25 = 10%. Therefore, the company’s cost of preferred stock amounts to 10%.
Another type of funding employed by the Vestor Corporation is the common stocks, which have covered 40% of the project funding requirements. Common stock financing has no fixed charges and maturity date. In most of the cases, it can be sold more easily compared to debt liabilities. Furthermore, common stock increases creditworthiness of the company and decreases financial leverage of the company’s capital structure. On the other hand, equity financing through common stock implies loss of control rights and dilution of the shareholders’ equity. It is also more expensive form of financing due to high rate of return required on this type of investment and significant underwriting and distribution costs. Dividends paid out to the shareholder are not tax deductible, therefore there is no effect of tax shield in using this type of financing (Ehrhardt & Brigham, 2016; Fernandez, 2002).
Following the case scenario provided, the company has issued common stock in the amount of $8,000,000. To evaluate the cost of equity financing, Capital Asset Pricing Model will be used. Capital Asset Pricing Model assumes that the return on assets depends on the systematic risk of those assets, or Beta coefficient. The cost of equity can be calculated by using the following formula:
Cost of Equity = Risk Free Rate + Beta * (Market Rate of Return – Risk-Free Rate)
Return on the 10-year Treasury note can be used as a proxy of the risk free rate, whereas the expected market return of the S&P 500 can be used as a market rate of return. Following the case information provided, the company’s cost of equity is equal to:
Cost of Equity = 3.5% + 1.2 * (13% – 3.5%) = 14.9%
Therefore, the company’s cost of equity amounts to 14.9%.
The Weighted Average Cost of Capital is weighted for the proportions of each source of financing used and the cost of each source of financing (Armitage, 2005). It should be noted that the after-tax cost of debt is included into the calculation, as debt liabilities such as bonds offer a tax shield advantage. Therefore, WACC of the Vestor Corporation can be calculated using the following formula (Ehrhardt & Brigham, 2016; Fernandez, 2002):
WACC = wdrd (1 t) + wprp + were, where
wd is the proportion of debt that the company uses when it raises new funds;
rd is the before-tax cost of debt;
t is the company’s tax rate;
wp is the proportion of preferred stock the company uses when it raises new funds;
rp is the cost of preferred stock;
we is the proportion of equity that the company uses when it raises new funds;
re is the cost of equity.
WACC = 50% * 6.4521% * (1 – 34%) + 10% * 10% + 40% * 14.9% = 9.1%.
WACC is able to provide the company’s managers and potential investors with an indication of how the market views the riskiness of the company’s assets and can help to determine the required return for capital budgeting projects. The proposed project of the Vestor Corporation provides the internal rate of return higher than the company’s weighted average cost of capital (11.5% > 9.1%). Therefore, the Vestor Corporation should make the warehouse investment. Calculated WACC rate should be used as a discount rate to evaluate NPV of the warehousing facility project.
- Armitage, S. (2005). The cost of capital: Intermediate theory. Cambridge University Press.
- Ehrhardt, M. C., & Brigham, E. F. (2016). Corporate finance: A focused approach. Cengage learning.
- Fernandez, P. (2002). Valuation methods and shareholder value creation. Academic Press.