What does calculating the weighted average cost of capital tell you about Foust Company鈥檚 financial strategy

including the level of risk involved in the business? How could the company use WACC calculations in determining future investment?




The following tabulation gives earnings per share figures for the Foust Company during the
preceding 10 years. The firm鈥檚 common stock, 7.8 million shares outstanding, is now (1/1/03)
selling for $65 per share, and the expected dividend at the end of the current year (2003) is
55 percent of the 2002 EPS. Because investors expect past trends to continue, g may be based
on the earnings growth rate. (Note that 9 years of growth are reflected in the data.)

YEAR EPS YEAR EPS
1993 $3.90 1998 $5.73
1994 4.21 1999 6.19
1995 4.55 2000 6.68
1996 4.91 2001 7.22
1997 5.31 2002 7.80
The current interest rate on new debt is 9 percent. The firm鈥檚 marginal tax rate is 40 percent.
Its capital structure, considered to be optimal, is as follows:
Debt $104,000,000
Common equity 156,000,000
Total liabilities and equity $260,000,000

Wow. This is a tough one.

First, the Weighted Average Cost of Capital (WACC) is a mixture of what it costs the firm to issue debt (the interest is tax deductable) and what it costs to issue new stock. Then, you weight the two based on the capital structure.

The cost of debt is easy...It's 9% times (1-tax rate) = .09(.60) = 5.4%.

The cost of equity has to be backed into by using the current price and the implied growth rate. You can use the formula Price = next year's dividend / (equity cost - growth rate)

I calculated the earnings growth rate over the past 9 years at 8%. So, next year's dividend is .55*(7.80)*(1.08) = $4.633

If $65 = 4.633/(k-.08), K = .1513 or 15.13%

The weight of debt and equity is based on the capital structure. So debt = 104/260 = 40% and equity = 60%.

The WACC = .4 (5.4%) + .6 (15.13%) = 11.238%

The WACC can be used as a benchmark, or hurdle rate, to determine which projects in capital budgeting should be accepted. It will cost the company an average of 11.24% to fund new projects, so it will need to generate at least an 11% return to break-even. Projects with expected returns below 11% should be rejected. Because the WACC incorporates both the cost of debt and teh cost of equity, it accounts for the relative risk of the company in terms of evaluating new projects.

I hope that helps!