Lenovo Group Ltd WACC

Running head: LENOVO GROUP LTD WACC 1

LENOVO GROUP LTD WACC 6

Lenovo group ltd WACC
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Introduction
Company assets are financed from both internal and external sources. Individuals who invest in companies therefore expect return thereon. For the internal financiers that is common equity shareholders, they receive their return in the form of dividends while external financiers such as lenders and preference shareholders are rewarded through interest and dividends respectively. These therefore mean costs to the company. It therefore calls for the managers to determine the average cost of such capital components and ensure that it is kept at an optimal level. One of the notable approaches used in determining the cost of capital components is the WACC. It is the average cost of the various capital components (Pratt & Grabowski, 2010). This report therefore seek to determine the weighted average cost of capital of Lenovo Group Co. Ltd. In addition, it will present critical evaluations of the effectiveness and reliability of the measure.
According to Brigham & Ehrhardt (2008),

Where:

The above formula however leaves out the preferred capital component since the capital structure of Lenovo Group Ltd does not involve that. However, if it were involved, we would have incorporated the same into the formula. The tables bellow therefore present the determination of each variable.

Company
Total Assets
Total Liabilities
Total Preferred Stock
Total Common Equity

Dollar Value (Mil)

1894.666
0
8942.470

% of Assets
100
17.48
0
82.52

Company
Income before Tax
Income Tax Expense
Average Tax Rate (%)

1715Mil
285.033Mil
16.62

Cost of debt
Yield to Maturity
1 – Average Tax Rate

117.25Mil
0.8338
5.1599%

Cost of equity
5-year Treasury Bond Yield
(risk-free rate)
Stock’s Beta
Return on the Top 500 Stocks (market return)

1.83%
1.27
9.33%
11.355%

Firm’s weighted average cost of capital (WACC)

After-Tax Cost of Debt
Cost of Preferred Stock
Cost of Common Equity
WACC

Unweighted Cost
6.1884%
8.167%
11.355%

Weight of Component
0.1748
0
0.8252

Weighted Cost of Component
0.01082
0
0.0937
10.27

Question 1
Differences are notable between WACC determined by the use of book values and when it is calculated based on market values. Literally, book values entail the value of assets as they appear in financial statements while market value of assets reflect the current prices in the market. WACC determined on the basis of market values would be relatively higher that the obtained value. This difference can be explained by the persisted changes in the general price levels in the market especially due to inflation and changing policies. Book values in a way ignore such changes and are hence regarded historical and relative lower that market values (Pratt & Grabowski. 2010).
Question 2
If common equity was financed through issuance of new stocks to new members, WACC will definitely increase. Selling new shares to member of the public attracts floatation costs. Such costs directly lead to an increase in the cost of common equity and consequently into an increase in weighted average cost of capital. Moreover, floatation of new shares lead to dilution of EPS since the number of shareholders increase and hence an increase in the WACC (Brigham & Ehrhardt, 2008).
Question 3
A couple of benefits accrue to firms from financing its assets with debt capital. Firstly, unlike equity financing that leads to dilution of ownership debt financing does not impact on ownership. Secondly, it is considered less costly from the view point that interest on loan is tax deductible. Lastly, it is considered less complex since the company is not obligated to adhere to statute laws and regulations. Despite these advantages, the method is also faced with a couple of disadvantages. For instance, the principal sum borrowed together with the interest accruing must be paid at some point. Moreover, loans are always associated with restrictive covenants. The also require attachment of a security or collateral (Brigham & Ehrhardt, 2008).
Question 4
Floatation costs are the costs incurred through the issue of new shares to new members (Pratt & Grabowski, 2010). They will increase the cost of equity capital and consequently into the WACC. Such costs are incorporated into the formula at the point of calculating the cost of common equity. They can also be incorporated in the determination of cost of debt capital.

References
Brigham, E. F., & Ehrhardt, M. C. (2008). Financial management: Theory & practice. Mason, Ohio: Thomson Business and Economics.
Pratt, S. P., & Grabowski, R. J. (2010). Cost of capital: Applications and examples. Hoboken, N.J: John Wiley & Sons.