Corporate Finance

a) WACC

A company’s weighted average cost of capital (WACC) is usually regarded as the minimum required rate of return. It is defined as the weighted average rate of return a company must pay to its long-term creditors and shareholders for the use of their funds. When WACC is used as the discount rate, it serves as a screening device in net present value analysis.

To calculate WACC we must first find the expected return on share i E(Ri), using the securities market line equation, as follows:
E(Ri) = RF + βi (E(RM) - RF)

= 3% + 1.2 (13% - 3%)

= 15%

E(Ri) = expected return on share i

E(RM) = expected return on the market = (Market risk premium + the risk free rate of return) = 13%
RF = risk-free rate of return = 3%

βi = beta of share i =1.2

As such, WACC can be calculated using the following equation:

WACC = [D/(D+E)*RD](1-T) + [E/(D+E)*RE]

= [40%*6%(1-28%)] + [60%*15%]

= 10.728%

D = value of total debt

E = value of shareholders’ equity

RD = cost of debt

RE = cost of equity

T = corporate tax rate

b) NPV, IRR, & Payback Period

Assumptions:

- Generally speaking, because of difficulties related to identifying costs with particular activities and determining the future benefits, all R&D costs are expensed when incurred. They do not become part of the capitalised investment asset. As such, the €20m OMG has spent on R&D will be excluded from the NPV calculations, since this cost will be incurred regardless of the decision to proceed with the project. - The scenario also implies that regulatory approval is well underway and is expected shortly. This suggests that the cost for such approval (€80m) has also been incurred regardless of the decision to go-ahead with the project. As such, this cost will also be excluded from the NPV calculations.