Calculating weighted average cost of capital for Alpha Leisure

Financial Management (case scenario)

The theoretical ex-rights price may be calculating the following way. We have the following known variables:

Fair value of all shares = 12,000,000 * 135 = 1,620,000,000

Total amount received from exercise of rights = 1,500,000*108 = 162,000,000

Number of shares prior to exercise = 12,000,000

Number of shares issued in the exercise = 1,500,000

Then, the theoretical ex-rights price is 1,620,000,000 + 162,000,000)/(12,000,000 + 1,500,000) = 132 cents

Hence, the value of a right is 3 cents..

The Alpha Leisure is issuing at a discount to make the shares more interesting for the investors. However, if we consider an investor from outside the company (one who doesn't have ordinary shares in the company until now), then he will purchase actions at 108 cents, plus the 24 cents per action, representing the 8 rights necessary to buy an action. In this way, the price will arrive at the ex-rights price, which would have been 132.

WACC can be calculated by multiplying the cost of each capital component by its weighting and then summing. As in our case, we have one debt element (debentures stock) and two equity elements (preference shares and common shares). Let's address each in part:

Total market value = $26,000,000

Total value of debt = 8.0 mil, that is 30.7%

Total value of preference shares = 8.0 mil =6.4%

Total cost of common shares = 57.8%

Then, WACC = a*kD + b* kP + c*kC, where a, b, c = weight in total value (as calculated above) and kD, kP and kC the cost of each source of capital. In order to evaluate WACC, we have to calculate in part kD, kP and kC.

A kD = D* (1-T), where T = corporation tax = 35% and D = 11%. This formula accounts for the fact that this expense is deductible. The final value for kD is kD = 7% kP = Dp/Pp, where Dp is the dividend paid for preference shares and Pp- price of preference shares.

A kP = 0.01 = 1% kC = D/P+g, where D- dividend paid, p- price per common share and g - rate of growth estimated over period of time kC = 18/135 + 0.08 = 0.21 = 21%

Then, the WACC can be calculated as WACC = 0.307*0.07 + 0.01*0.064 + 0.578*0.21 = 0.14 = 14% d) The Capital Asset Pricing Model could be used to evaluate the cost of the equity capital following the formula used in the model. In the formula, there are three unknown variables that we must evaluate before calculating the cost of equity: kRF is the rate of return of a non-risky asset, kM, the rate if return of a portfolio formed from all assets on the market (estimated) and ?, the beta coefficient of the asset.

However, as one can see, using the CAPM requires a series of estimates that we have to provide. If, in the case of the kRF, things are pretty simple, as we can use the return of T-bills, for example, in the case of the kM and the B, these are harder to estimate and, one should remember, it is only estimates we are working with.

A e)

Initial costs

Cost ($)

18 months of development

Future design expenditure

Machinery Overhaul

Labor Force Training

Redundancy Wage Settlement

Total Initial Cost: $4,200,000

In calculating the initial total costs, I have taken into consideration all spending that the company has already paid, as well as several payments that it will certainly pay in the future, such as the wage settlement.

Number of units sold

Price per unit ($)

Cost of Cylon per annum

The cost of Cynthex per annum is obtained by multiplying the necessary amount of material (2 kg) with the number of units produced each year (4,000) and by the cost of 1 kg of cynthex ($65). As for the cylon, this is calculated in the same manner, but note that in the first year, we must subtract the 2,500 kg that the company already has in stock from the total yearly amount of 4,000 kg necessary. This explains the difference in cost between the first year and the rest of the years.

Labor requires a cost of $500,000 per each year, as for the whole production of clux, 20,000 hours of labor are necessary, at a rate of $25 pert hour. Additionally, we must also include the incremental overheads associated with production, as in the table below:

Incremental overhead ($)

The total spendings and revenues per year are given in the table below:

Revenue ($)

Spending and Expenses ($)

Cash Flow

The chart below shows a graphical representation of the cash flows for years

1-5. As we can see, the initial cash flow, in year 1, is greatest. The cash flow in year 2 decreases, but rises the subsequent 3 years. This can be explained by the fact that, in the first year of production and sales, the costs of production are smaller (mainly because some of the materials are in stock). The rise in value of the subsequent cash flows form years 3-5 derives from the increase in the price per unit produced and sold.

The actualized value of the future cash flows, using a rate of return on investment of 12% is $4,796,206. If we subtract from this the initial cost, we will have a net present value (NPV) of $596,206. If we resume our findings, we have calculating a series of cash flows for the next 5 years of selling the product. These cash flows were actualized by using k = 12% and compared to the initial spending on the project. The cash flows are greater: if we subtract the initial cost, the value remained is positive, which means that the investment is sound and will bring added value.