# Weighted Average Cost of Capital Oz Assignments

## Part A:

### Calculation of Weightage average cost of capital of Gamewhirl Group

Data Given for both type of Capital (Equity and Debt)

 Equity Capital Number of equity Shares 40000000.00 Current Market Price of Equity Share £ 2.87 Beta of company 0.716 Risk free rate of return (Yield on government bonds) 2.50% Average stock market risk premium 5.50% Average annual return on the stock market 8.00%
 Bonds (Debt Capital) Market price of bond £ 102.50 Par value of bond £ 100.00 Total par value of bond £ 45,000,000.00 Number of bond issued 450000.00 Beta value of bonds Zero

Cost of Equity (CAPM Model) = Risk free rate+ Beta*Market risk premium

Cost of debt = (Annual Interest rate / Market price) * (1-tax rate) (Garrett, 2008)

 Cost of Equity 6.44% Cost of Debt (Bond) 4.80%

Formula of WACC: (E/V * Ke) + (D/V) * Kd * (1 – Tax rate)

 Calculation of WACC Capital Total Value Weights Rate AT Weighted Cost Debt Part £ 46,125,000.00 0.286624 4.80% 1.38% Equity Part £ 114,800,000.00 0.713376 6.44% 4.59% WACC 5.97%

Evaluation of Investment Project "Vision 2020”

 Initial Cost Year 0 £ 17,500,000.00 Year 1 £ 7,500,000.00 Total Cost £ 25,000,000.00 Revenue in year 1 £ 12,000,000.00 Revenue growth every year 6% Operating Cost 55% of Revenue Inflation rate 3%
 Calculation of depreciation Total Cost At Year 0 £ 17,500,000.00 Depreciation for year 1 to 5 £ 3,500,000.00 Total Cost At Year 1 £ 7,500,000.00 Depreciation for year 2 to 5 £ 1,875,000.00
 Particulars Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Cash Inflows Revenue £ 12,000,000.00 £ 13,101,600.00 £ 14,304,326.88 £ 15,617,464.09 £ 17,051,147.29 Less: Operating Cost £ 6,600,000.00 £ 7,205,880.00 £ 7,867,379.78 £ 8,589,605.25 £ 9,378,131.01 Less: Depreciation £ 3,500,000.00 £ 5,375,000.00 £ 5,375,000.00 £ 5,375,000.00 £ 5,375,000.00 Profit after dep before tax £ 1,900,000.00 £ 520,720.00 £ 1,061,947.10 £ 1,652,858.84 £ 2,298,016.28 less: tax @ 18% £ 342,000.00 £ 93,729.60 £ 191,150.48 £ 297,514.59 £ 413,642.93 Profit after tax and after tax £ 1,558,000.00 £ 426,990.40 £ 870,796.62 £ 1,355,344.25 £ 1,884,373.35 Add: Depreciation £ 3,500,000.00 £ 5,375,000.00 £ 5,375,000.00 £ 5,375,000.00 £ 5,375,000.00 Profit after tax and before dep £ 5,058,000.00 £ 5,801,990.40 £ 6,245,796.62 £ 6,730,344.25 £ 7,259,373.35 Total Cash Inflows £ 5,058,000.00 £ 5,801,990.40 £ 6,245,796.62 £ 6,730,344.25 £ 7,259,373.35 Cash Outflows Initial Setup Cost Year 0 -£ 17,500,000.00 Year 1 -£ 7,500,000.00 Total Cash outflows -£ 17,500,000.00 -£ 7,500,000.00 £ - £ - £ - £ - Net Cash Flows -£ 17,500,000.00 -£ 2,442,000.00 £ 5,801,990.40 £ 6,245,796.62 £ 6,730,344.25 £ 7,259,373.35 Internal Rate of return 8.10%

 Decision: As per the current company policy company should invest in Vision 2020 because the IRR provided the Vision 2020 is 8.10 % which is greater than the IRR hurdle rate of 5.97% (WACC).

Part B:

In this question the point of concern is to calculate the tailored hurdle rate for the purpose of internal rate of return. Gamewhirl Group has two divisions Optix 21 and Helpdex’ and both these division have different level of revenue. Both the divisions have different associated risks according to type of business they operate in. So it is important to consider the segmental betas of for each division. Please see below formula to have an idea to calculate the segmental beta of division Helpdex Division (This division is considering taking new investment and economics project “Vision 2020” (Erickson, 2013).

Below table calculates divisional betas of Gamewhirl Group from the given information:

 Division Activity Revenue % of shares of sales Surrogate Company Beta Weighted Beta Optix 21 Division service provider to video games production companies £ 24.31 85.00% Similar company given in question 0.706 0.6001 Helpdex Division video games developer £ 4.29 15.00% No information 0.773 0.1159 £ 28.60 Beta of Company given in question 0.716

The cells highlighted in above table are calculated figure as beta value of company is provided in the question that helps to calculate the beta of Helpdex Division.

Now there is requirement to calculate the project cut off rate or tailored required rate of return to be used as hurdle rate for evaluation of the investment project. Here there is need to consider the project beta of the project taken by the Helpdex Division. There is need to adjust the beta value of division according to the project risk factor.

Project risk factor = Revenue Sensitivity factor (RSF) * Operating gearing factor (OGF) (Peterson, 2012)

RSF = Rise in sales value of investment project / Rise in sales of division

 Calculation of RSF Sales from project year 1 \$ 12,000,000.00 Sales from project year 2 \$ 13,101,600.00 Sensitivity percentage of project 9.18% Sales from division previous year \$ 16,290,000.00 Sales from division after application of project \$ 17,391,600.00 Sensitivity percentage of division 6.76% Revenue Sensitivity factor (RSF) 1.3575
 Calculation of OGF Here operating gearing factor is assumed to be 1 as it all project is finance through debt capital not with equity capital.

Project risk factor: 1 * 1.3575 = 1.3575 (Fabozzi, 2007)

Project beta = Divisional beta * project risk factor = 0.773* 1.3575 = 1.049

Required rate of return = risk free rate of return + project beta * market risk premium

= 2.5 % + 1.049 * 5.5% = 8.2695%

Tailored hurdle rate of the project = 8.2695%

 So, on the basis of re-evaluation of Vision 2020 investment project on the basis of IRR of 8.10% and its tailored hurdle rate of 8.2695%, investment project must not be taken by the Helpdex Division Gamewhirl Group.

Part C:

The use of single company-wide hurdle rate like WACC or any other rate for evaluating the specific project does not provide a reasonable risk categorization of the undertaken project. There may be many divisions in a company that have different risks associated with them and using a beta value of whole company will not provide the exact risk associated with a project undertaken by any specific division. The use of company-wide hurdle rate will be suitable for the replacement project but it is not suitable for any major project undertaken by company such new product development or acquisition of any new company belonging to sector not related to the company current sector. So it can be said that if the return produced by the new project is positively related with the risk involved in it, than the companies who uses single discount rate (Hurdle rate) will end up with the overinvesting risky projects as compared to the less risky projects. It means the evaluation of project using various techniques of capital budgeting will be of no use as risk associated with the project has not be given proper consideration by the company who is using the single company-wide hurdle rate.

It has been seen in many cases that multi divisional companies poses different activities that has different degrees of risk. So to support the relation it can be said that beta of whole company will weighted average of each divisional betas calculated on the basis of risk associated with each type of activity carried out by the division. As risk associated with individual share contributes to overall risk associated in portfolio, similarly it can be said that each division contributes to company overall business risk (Klein and Iammartino, 2009). The risk of using a single discount rate to evaluate the new project can be been in below graph:

On the basis of above graph it can be said that Gamewhirl Group has two divisions; Optix 21 division and Helpdex division. On the basis of calculation performed in question 2, it is clear that Helpdex has higher beta value than the company overall beta, whereas Optix 21 has lower beta value as compared to company beta. So it is important to use higher than average discount rate for appraising the new project undertaken under Helpdex Division, on the other hand there is need to consider lower discount rate than the average if project is undertaken in Optix 21 division. It is done because internal rate of return calculated for the new project must be evaluated through comparing it with the hurdle rate of division irrespective of hurdle rate of whole company. Here hurdle rate means required rate of return or WACC.

So it is advised to the Gamewhirl to apply the tailored hurdle rate to appraisal the investment project. It is because current project is undertaken by the Helpdex division and has high degree of risk associated with it. The risk associated with the project is different from the risk in overall company. In order to give preference to the risk in project it is required to adjust the beta value of division to project risk factor. Project risk is calculated using the sensitivity in revenue from project and division and operating gearing position in division and project (Lossen, 2007).

Part D:

Report to the CFO of Gamewhirl Group plc

The major disadvantage of IRR is that it assumes that cash flows from the project are reinvested at calculated internal rate of return but in real it is not possible. IRR is based on the unrealistic assumption that in future equally good investments are readily available at all points that allows to reinvest the money at same earned from previous investment. It means any positive cash flows that have been generated during the life of project are reinvested in a project that will also generate same amount of cash flows as the previous project. In real life it is really impossible to predict the future conditions of market. The major disadvantage of IRR is that it cannot be applied when investment size differs with very great amount. For example, a rate of return on investment worth 100000 pounds is 20% while rate of return on investment worth 10000 pounds is 45% than IRR will ignore the pound value of return received and select later project due to higher IRR whereas company will profitable when they will invest in first investment due to higher pound value (Brigham and Houston, 2012).

To overcome all the limitation of IRR, Modified internal Rate of return (MIRR) has been preferred. The two major drawbacks of IRR that are solved through using MIRR are elimination of multiple IRRs where the investment is made in made project having unusual timing of cash flows (i.e. cash flow timing are not even) and also it solve the issue of reinvestment problem through considering that reinvestment are made at cost of capital not at the internal rate of return. It also overcome the problem of size of investment s it measures the sensitivity of investment with the variation of cost of capital.

Formula to calculate the modified IRR:

Example: Consider an investment that requires outflow of 250000 pound of initial investment and generates the following cash inflows:

 Year Amount 0 Outflow of 250000 pounds 1 Inflow of 50000 pounds 2 Inflow of 100000 pounds 3 Inflow of 200000 pounds

Cost of capital of investment is given as 13%

Solution:

Step 1: Terminal value of cash inflows discounted using the cost of capital: 376845 pounds

Step 2: Present value of cash investment initially: 250000 pounds

Step 3: Application of MIRR formula: