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Estimating the Cost of CapitalSection BEstimating the Cost of CapitalWACC

ACCA · Question 23 · Estimating the Cost of Capital

Section B - Case 2: NeuroLink Prosthetics

Scenario: NeuroLink Prosthetics is a MedTech firm. It has 10 million ordinary shares in issue, currently trading at $4.50 per share. The company's equity beta is 1.2. The risk-free rate of return is 4% and the expected return on the market portfolio is 10%. NeuroLink also has $15 million (nominal value) of 6% redeemable bonds, currently trading at $95 per $100 nominal, redeemable at par in 5 years. The corporate tax rate is 25%.

Assume the cost of equity (Ke) is 11.2% and the after-tax cost of debt (Kd) is 5.7%.

Question: What is NeuroLink's Weighted Average Cost of Capital (WACC) based on market values?

Answer options:

A.

8.45%

B.

9.88%

C.

10.12%

D.

11.20%

How to approach this question

First, calculate the total market value of equity (Shares * Price) and debt (Nominal / 100 * Market Price). Then apply the WACC formula: [Ve / (Ve + Vd)] * Ke + [Vd / (Ve + Vd)] * Kd.

Full Answer

B.9.88%✓ Correct
Step 1: Calculate Market Values. Ve = 10,000,000 shares * $4.50 = $45,000,000. Vd = $15,000,000 * ($95 / $100) = $14,250,000. Total Value (V) = $45m + $14.25m = $59.25m. Step 2: Calculate WACC. WACC = (Ve / V) * Ke + (Vd / V) * Kd WACC = ($45m / $59.25m) * 11.2% + ($14.25m / $59.25m) * 5.7% WACC = (0.7595 * 11.2%) + (0.2405 * 5.7%) WACC = 8.506% + 1.371% = 9.877% (rounded to 9.88%).

Common mistakes

Using the nominal value of debt ($15m) instead of the market value ($14.25m) for the weightings.
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