Weighted Average Cost of Capital

 Weighted Average Cost of Capital (WACC)

Instructions/Descriptions

Estimating the Weighted Average Cost of Capital (WACC)

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Question Description

An investor is considering starting a new business whilst working with a local government as Accountant. The company would require GHS 500,000 of assets, and it would be financed entirely with common stock. The investor will go forward only if he thinks the firm can provide a 15.0 percent return on the invested capital, which means that the firm must have a ROE of 15.0 percent. After operating the business for 5 years, he realized the importance of debt and tax deductibility that comes with it.

He then decided to alter the capital structure whilst expanding the size of the business. His total assets came to GHS 647m financed as follows:
Market value of Debt= GHS 194m with 11%
Market value of Equity= GHS 453m with expected return of 17%
Just as he was about obtaining an additional loan in 2020, Covid-19 and its containment measures (such as social distancing, stay at home etc) affected his business which operated more with human interaction. The three-week partial lockdown has affected the going concern of his business.

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Government has set up the Coronavirus Alleviation Programme (CAP) with seed money of GHS 1 billion. An amount of GHS 600 million of this money is to be disbursed to vulnerable firms and GHS 400m to vulnerable households. The government also announced free water for three months (April to June 2020) to all citizens consistent with the health protocols of washing hands as often as possible under running water though one-third of the African population cannot wash their hands simply because of lack of running water.

For the three months, electricity has been zero-rated for lifeline consumers (from 0-50 kilowatt-hours a month consumption) whilst all other categories of consumers enjoy a 50% subsidy. Given the enhanced exposure of frontline workers as a result of the pandemic, the government also offered tax exemptions amounting to 50% of their basic salary for the three months translating to fiscal loses of GHS 288.6m including additional allowances for frontline health personnel covering March, April, May, and June for the year 2020 (amounting to GHS 51 million).

But the Accountant has complained for his exclusion from the list of beneficiaries. Bank of Ghana (BoG) also responded by reducing the policy rate by 150 basis points as well as reducing the Primary Reserve Requirement from 10% to 8%. His bank loan is indexed to the primary reserve requirement and varies accordingly. Given the above and your own understanding of recent development with respect to Covid-19: Attempt the following questions (you are free to make reasonable assumptions)

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A) How much net income must be expected to warrant starting the business? (3 Marks)
B) Estimate the Weighted Average Cost of Capital (WACC) of the business before and after Bank of Ghana’s Covid-19 intervention and interpret your results. Assume a tax rate of 25% (10 Marks)
C) Ascertain the minimum profit the business must make in order to satisfy providers of capital before and after BoG’s Covid-19 intervention.
i. (5 Marks)
D) Using your understanding of risk and returns, is the complaint of his exclusion from the tax rebate justified (3 Marks)
E) Discuss how government’s Covid-19 fiscal stimulus would benefit his business and how he can take advantage of them. (8 Marks)

Estimating the Weighted Average Cost of Capital (WACC)

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