Investopedia accessed

Investopedia ,
accessed March 29, 2016, -
disadvantages-gordon-growth-model.asp.
23 “Cost of Debt,” Investopedia , accessed March 25, 2016, .

15
࠵?
c
=
125 162 000 ࠵? 4.14%
125 162 000
= 4.14%
This rate is then adjusted to account for taxes by the following method:
࠵?
c
= 4.14% ࠵? (1 − 30%)
= 2.90%
3.3 Weighted Average Cost of Capital
The weighted average cost of capital (WACC) is defined as a weighted average of cost and
return. It is neither a cost nor a return. The WACC of a company is calculated by multiplying the
weights of debt and equity with their respective cost of debt and equity correspondingly.
࠵?࠵?࠵?࠵? = ࠵?
R
࠵?
Rh
࠵?
c
࠵?
c(
1 − ࠵?࠵?࠵?)
After evaluating and comparing the two models, it has been decided to use the DGM as the cost
of equity. The value of equity is obtained by multiplying the number of shares at 30 June 2015
by the closing price of $2.09 recorded at 29 June 2015. The value of debt is the non-current
liability borrowing found on the balance sheet.
࠵?
R
=
࠵?࠵?࠵?࠵?࠵?࠵?࠵? ࠵?࠵?࠵?࠵?࠵? ࠵? ࠵?࠵?࠵?࠵?࠵?࠵? ࠵?࠵? ࠵?ℎ࠵?࠵?࠵?࠵?
(࠵?࠵?࠵?࠵?࠵?࠵?࠵? ࠵?࠵?࠵?࠵?࠵? ࠵? ࠵?࠵?࠵?࠵?࠵?࠵? ࠵?࠵? ࠵?ℎ࠵?࠵?࠵?࠵?) + ࠵?࠵?࠵?࠵?࠵?࠵?࠵?࠵?࠵?࠵?
=
\.P_ k QPP ]lm P‘\
(\.P_ k QPP ]lm P‘\)hQ\‘ Qn\ PPP
= 0.63
࠵?
c
=
࠵?࠵?࠵?࠵?࠵?࠵?࠵?࠵?࠵?࠵?
(࠵?࠵?࠵?࠵?࠵?࠵?࠵? ࠵?࠵?࠵?࠵?࠵? ࠵? ࠵?࠵?࠵?࠵?࠵?࠵? ࠵?࠵? ࠵?ℎ࠵?࠵?࠵?࠵?) + ࠵?࠵?࠵?࠵?࠵?࠵?࠵?࠵?࠵?࠵?
=
125 162 000
(2.09 ࠵? 100 387 052) + 125 162 000
= 0.37

16
࠵?࠵?࠵?࠵? = (0.63)(10.59%) + (0.37)(2.90%)(1 − 30%)
=7.42%
3.4 Interpretation of Weighted Average Cost of Capital
The cost of equity, calculated through CAPM or DGM, is needed to compute the weighted
average cost of capital. However, due to the several non-realistic assumptions linked to either
method, the calculated WACC is inaccurate. Even if the calculated WACC was reliable, it could
only be used for new projects having the same capital structure and risk profile as existing
projects of the company. 24 Moreover, the WACC calculated will be different if either CAPM or
DGM is used.
The weights of the debts and equity are used to calculate the WACC. With time, the capital
structure of the company, that is the proportions of debt and equity might change according to
the financing decisions. Since equity is riskier than debts in terms of repayments in case of
liquidation in which debt holders are repaid first, the return for equity is higher. 25 Increasing the
debt financing of the company will decrease the WACC. This is because when debt increases,
though return on equity increases, the tax shield associated with debt increases much more than
equity which causes the WACC to decrease. Similarly, if the equity portion is increased, the
WACC will increase.