Mchunguzi Limited has compiled the following information on its financing costs:
(a) The Weighted Average Cost of Capital (WACC) using:
(i) Book-value weights.
(ii) Market-value weights.
(b) Explain the differences between the three WACC calculated in (a) above. What are the correct weights to use in the WACC calculation?
(c) Mchunguzi‟s Ltd.‟s subsidiary company, Ottamax Ltd. is considering undertaking a warehouse renovation at a cost of Sh.50 million. The warehouse is expected to yield cost savings of Sh.12 million a year for six years. Ottamax Ltd. has a current debt-equity ratio of 60%, a cost of debt of 25 per cent and a cost of equity of 13.5%. The corporate tax rate for such a firm is 30%.
Using appropriate computation, advise Ottamax Ltd. on whether it should undertake the renovation.
(b) The differences in the WACCs arise because of the value of the weightings using market value weights gives a higher WACC because equity has a heavier weighting. The market value weights are the right weights to use as they reflect the true value of equity and debt unlike the book value weights which are accounting values and they make use of historical costs.