Dukane Electric Company

Computation of Cost of Capital

Brajesh Kumar (MP12015)
Santosh K Singh (MP12063)
Rakesh Agarwal (MP12054)
Amit Bharti (MP12005)
George Verghese (MP12021)
Case Study Overview
DEC was a company engaged in public distribution of electricity with $172M sales in
last fiscal year.
It planned for a major construction programme to expand customer base.
Construction budget estimated at over $500 M with approximately 60% finance from
internal resources.
New capital investment requires the company to earn a reasonable rate of return for
its capital providers.
The above return must be decent enough to cover the cost of capital, also known as
WACC.
Challenges ahead for WACC Inflation, increasing wage cost and higher operating
cost.
Shareholders expectation Comparable earning, capital attraction and maintain
credit standing.
Case Study Overview contd


Computation of WACC has many inferences like using of different model
for cost of equity and application of different weights (market or book or
target).
What is the most appropriate method to compute WACC.

Why the WACC
Measures the returns demanded by all
providers of capital
Investments must offer this return to be worth
using the capital providers money
As an opportunity cost
The rate of return investors could earn elsewhere
on projects with the same risk and capital
structure
Methods for WACC Computation
Cost of Equity
Discounted Cash Flow Method (DCF)
Capital Assets Pricing Model (CAPM)
Weighted Average Cost of Capital (WACC) using
Book Value as weight
Market Value as weight
Target Value as weight
Decide : Most Appropriate Method (MAM) for WACC

Cost of Equity DCF Method
D1 = Do X (1+g) = 1.14 X 1.08 = 1.23
Po = 16.125

Cost of Equity (Ke) = [D1 / Po] + g
= 1.23/16.125 + 0.08
= 15.61%
Rm = Return on market portfolio = 13%
Rf = Risk-free rate of return = 7.50%
Beta = 0.90
Cost of Equity (Ke) = Rf + (Rm-Rf) X Beta
= 7.50 + (13-7.50) X 0.90
= 12.45%
Cost of Equity CAPM Method
Calculation of Different Weights
Component-wise Cost of Capital
Cost of Preference Share (Kp)
= Div. / Market Price (net of floatation cost)
= 2 / 20 X 100 = 10%

Cost of Equity (Ke)
15.61 % (DCF Model)
12.45 % (CAPM Model)

Pretax Cost of Debt (Kd)= 8%
WACC Computation (Book Value,
Market Value & Target Value)
MV Weight Vs BV Weight
Provides better yardstick of investors expectations.
Based on market sentiments and not affected by
accounting entries in the books.
Provides fair estimate of cost of capital in relation to
listed corporations.
Difficult to compute since market value is based on
estimates and subject to different individual inferences.

Most Appropriate Method
We recommend WACC (TARGET WEIGHT) for the following
reasons

More dynamic compared to Market Weight and reciprocates
the investor expectations in current market scenario after
raising the new capital.

Target weights are management internal commitment which
they need to achieve in the long run.

Target weight attempts to incorporate the risk profile of the
firm in the industry, which in turn affects the WACC of the
firm.