Given information:

Market Value of Company A Source of Capital Percent of total Rate of return
Bonds 40% 6.2%
Preferred Stocks 10% 8%
Common Stocks 50% 12.4% Total: 100%

Task A: Calculation of Weighted Average Cost of Capital (WACC)

Formula for WACC = [D/V(1-Tc)Rd] + (E/V x Rc) + (E/V x Rp)

Where:

D/V = percentage of financing that is debt E/V = percentage of financing that is equity Tc = Corp. Tax Rate Rd = return on debt Rc = return on common stock (equity) Rp = return on preferred stock (equity)

Computation:

WACC = (.40 x .062) + (.50 x .124) + (.10 x .08)

= .0248 + .062 + .008

WACC = .0948 or 9.48%

This means that it will cost the Company A 9.48% for every $100 raised through debt & equity, base on the given weight. This is also represented the minimum rate of return after tax that Company must earn on this project in order to provide a fair return to its investors.

Task B1: Explanation of how cost of capital is used in net present value analysis

Before deciding whether or not to invest money into a project that generates a certain rate of return or a certain amount of money (cash inflow or cost of capital), investor or management would like to first estimate the future rate of return (future cash flow) and then discount it to today’s rate/value (present value). The difference between these present rates of return or cash flows is called net present value. The cost of capital is generally measured as weighted average cost of capital (WACC).
For Company A, the WACC is 9.48%. If the proposed project generates an expected future rate of return of the present value greater than 9.48%, then this generates a positive net present value and therefore, is considered a good project and it should be accepted. On the