Question

1. Lufthansa Airways studies and evaluates an expansion project where the calculation of the WACC is required. Lufthansa is currently financed by debt, preference capital and ordinary equity. The firm faces a company tax rate of 35%. The following information is available.

Debt: The firm currently has 35,000 bonds on issue. The current market value of each bond is $1020, the before tax cost of issuing new bonds would be 6% per annum.

Preference Capital: The firm currently issued 500,000 preference shares. The fixed amount of preferred dividends is $7, and the value of each preferred share is $70.

Ordinary Capital: 7,000,000 ordinary shares are currently on issue and the current ordinary share price is $25 per share. The company beta is 2, the risk free rate of return is 1.5% and the return on market portfolio (Rm) is 7%

Given the above information, find the weighted average cost of capital for Lufthansa.

Answer 1

The weighted average cost of capital is computed as shown below:

= cost of debt x (1 - tax rate) x weight of debt + cost of preferred stock x weight of preferred stock + cost of equity x weight of equity

weight of debt is computed as follows:

= Value of debt / (value of debt + value of preferred stock + value of equity)

= (35,000 x $ 1,020) / (35,000 x $ 1,020 + 500,000 x $ 70 + 7,000,000 x $ 25)

= $ 35,700,000 / ($ 35,700,000 + $ 35,000,000 + $ 175,000,000)

= $ 35,700,000 / $ 245,700,000

= 0.145299145

weight of preferred stock is computed as follows:

= Value of preferred stock / (value of debt + value of preferred stock + value of equity)

= (500,000 x $ 70) / (35,000 x $ 1,020 + 500,000 x $ 70 + 7,000,000 x $ 25)

= $ 35,000,000 / ($ 35,700,000 + $ 35,000,000 + $ 175,000,000)

= $ 35,000,000 / $ 245,700,000

= 0.142450142

weight of equity is computed as follows:

= Value of equity / (value of debt + value of preferred stock + value of equity)

= (7,000,000 x $ 25) / (35,000 x $ 1,020 + 500,000 x $ 70 + 7,000,000 x $ 25)

= $ 175,000,000 / ($ 35,700,000 + $ 35,000,000 + $ 175,000,000)

= $ 175,000,000 / $ 245,700,000

= 0.712250712

cost of preferred stock is computed as follows:

= Annual dividend / value of preference share

= $ 7 / $ 70

= 10% or 0.10

cost of equity is computed as follows:

= risk free rate + beta x (return on market - risk free rate)

= 1.5% + 2 x (7% - 1.5%)

= 12.5% or 0.125

So, the WACC will be computed as follows:

= 0.06 x (1 - 0.35) x 0.145299145 + 0.10 x 0.142450142 + 0.125 x 0.712250712

= 10.89% Approximately

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