ACCA · Question 32 · Estimating the cost of capital

Section C

AeroForge PLC - Cost of Capital

AeroForge PLC manufactures specialized components for the aerospace industry. The company is looking to calculate its Weighted Average Cost of Capital (WACC) to appraise future investments.

The company's capital structure is as follows:

Equity:
AeroForge has 10 million ordinary shares in issue, currently trading at $4.50 per share.
The company's equity beta is estimated to be 1.20.
The current risk-free rate of return is 3.0%, and the expected return on the market portfolio is 10.0%.

Debt:
AeroForge has $20 million (nominal value) of irredeemable bonds in issue. The bonds pay an annual coupon of 6%.
The current market price of the bonds is $95.00 per $100 nominal value.

Other Information:

• The corporate tax rate is 20%.
• AeroForge intends to maintain its current capital structure proportions for the foreseeable future.

Required:

(a) Calculate the Cost of Equity for AeroForge PLC using the Capital Asset Pricing Model (CAPM). (4 marks)

(b) Calculate the after-tax Cost of Debt for the irredeemable bonds. (4 marks)

(c) Calculate the Weighted Average Cost of Capital (WACC) for AeroForge PLC. (6 marks)

(d) The directors of AeroForge are considering diversifying into the commercial drone delivery market. Discuss whether the current WACC calculated in part (c) would be appropriate to appraise this new project, and explain how a project-specific discount rate could be determined. (6 marks)