A new cross-country, trans-mountain water pipeline needs to be built at an estimated first cost of $200,000,000. The consortium of cooperating companies has not fully decided the financial arrangements of this adventurous project. The WACC for similar projects has averaged 10% per year. (a) Two financing options have been identified. The first requires an investment of 60% equity funds at 12% and a loan for the balance at an interest rate of 9% per year. The second option requires only 20% equity funds and the balance obtained by a massive international loan estimated to carry an interest rate of 12.5% per year, which is, in part, based on the geographic location of the pipeline. Which financing plan will result in the smaller average cost of capital? (b) If the consortium CFOs
have decided that the WACC must not exceed the 5-year historical average of 10% per year, what is the maximum acceptable loan interest rate for each financing option?
What will be an ideal response?
(a) Calculate the two WACC values.
WACC1 = 0.6(12%) + 0.4(9%) = 10.8%
WACC2 = 0.2(12%) + 0.8(12.5%) = 12.4%
Use option 1 with a D-E mix of 40%-60%
(b) Let x1 and x2 be the maximum costs of debt capital
Option 1: 10% = 0.6(12%) + 0.4(x1)
x1 = [10% - 0.6(12%)]/0.4
= 7%
Debt capital cost would have to decrease from 9% to 7%
Option 2: 10% = 0.2(12%) + 0.8(x2)
x2 = [10% - 0.2(12%)]/0.8
= 9.5%
Debt capital cost would have to decrease from 12.5% to 9.5%
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