Could there be other errors in his calculations?
WACC was incorrectly based on book values not market values.
Correct formula is
WACC=[B/V x (1-Tc)rBank] + [D/V x (1-Tc)rdebt] + (P/V x rpreferred) + (E/V
x r Market Values of Securities
B= Bank Loan= $120 million
D= Long term Debt = $80 million
P= Preferred Stock = 1 million shares x $70(market value) = $70 million
E= Common Stock = 10 million shares x $40 (market value) = $400 million
V= $120+$80+$70+$400= $670 million
Tc= Corporate Tax Rate = 35%
rBank = 8%
rdebt = 7.75%
rpreferred = Dividend/ Mkt. Price of Preferred Stock = $6/$70 = 8.57%
requity = CAPM rate = 10.5%
or Dividend Discount Model (DDM)= requity= DIV1/Po + g =
($2/$40) + 6.7% = 11.7%
WACC (based on CAPM)= 8.7%
WACC (based on DDM)= 9.4%
Discount or Hurdle rate should be between 8.7% and 9.4%
What if Mr. Brinepool’s cost of equity was wrong?
If cost of equity is incorrect, then the weighted-average cost of capital (WACC) will be
skewed. A corporation, to assess the desirability of a potential capital expenditure, uses the
WACC as a benchmark. When care is not taken to properly calculate WACC, profitable projects
can be dismissed or projects may be engaged that do not provide an ample return to the
stockholders.
Is there some other way to estimate the cost of equity as a check on the CAPM calculation?
The DDM method : 11.7%
Dividend Discount Model (DDM)= requity= DIV1/Po + g =($2/$40) + 6.7% = 11.7%
equity)
