Question

Dorset Ltd is all-equity financed and has a cost of capital of 16 per cent per annum. An observer suggests that Dorset could easily borrow up to 40 per cent of the value of its assets at an interest rate of 10 per cent per annum and achieve a rating for its debt of A+ or better. He argues that raising new capital by borrowing would lower the company’s cost of capital, and increase the net present value of some projects that were recently rejected. Use a numerical example to illustrate the observer’s argument. Is his argument correct? Give reasons for your answer.

Answer 1

Yes. Generally Debt holders will expect lesser ret.

If source of finance is mixed with debt then WACC will be reduced and resulted into more NPV.

Ex: All Equity Case & Disc Rate @16%:

Year	CF	PVF @16%	Disc CF
0	$ -70,000.00	1.0000	$ -70,000.00
1	$ 30,000.00	0.8621	$ 25,862.07
2	$ 57,000.00	0.7432	$ 42,360.29
NPV			$   -1,777.65

Ex: 60% Equity & 40% debt Case & Disc Rate @WACC%:

WACC = weighted Avg Cost of sources in capital structure'

Source	Weight	Cost	Wtd Cost
Equity	60%	16%	9.60%
Debt	40%	10%	4.00%
WACC			13.60%

NPV Calculation:

Year	CF	PVF @13.60%	Disc CF
0	$ -70,000.00	1.0000	$ -70,000.00
1	$ 30,000.00	0.8803	$ 26,408.45
2	$ 57,000.00	0.7749	$ 44,169.06
NPV			$        577.51

Pls comment, if any further assistance is required.