Answer to Question #267618 in Economics for Nhlaphu

Question

Vhembe Limited has a target capital structure of 60% equity and 40% debt. The before-tax of debt is 8.50% and the cost of new equity is 12%. Tax rate is 28%. The finance manager is currently

considering a project with an expected return of 14% which will be financed from the issue of ordinary shares as all retained income is already budgeted for in more profitable projects. The

company recently issued debentures therefore, the present capital is more heavily weighted towards debt.

Required:

(a) Calculate WACC for Vhembe Limitd using the target capital structure. (4 Marks)

(b) Briefly explain (giving reasons) whether the project under consideration should be accepted or not. (5 Marks)

Answer 1

(a) WACC for Vhembe Limited using the target capital structure is:

$WACC = 0.12×0.6 + 0.085×0.4×(1 - 0.28) = 0.0965$

or 9.65%.

(b) The weighted average cost of capital (WACC) tells us the return that lenders and shareholders expect to receive in return for providing capital to a company.

If an expected return of the project is 14%, then it should be accepted.