Increasing level of debts increases the financial risk of a company which eventually increases the cost of equity as well. The weighted average cost of capital of highly geared company is higher as compared to the others.
In the given case study, the company, vagabond plc, is not a highly geared company as against every £ 0.67 worth of debt, the company has £ 1 worth of equity. In order to calculate the weighted average cost of capital of the company, the market value of equity and debt instrument is need to be calculated. The shares of Vagabond plc are currently traded at 36 pence which makes the total market value of the equity to £720 million. In order to calculate the cost of equity (ke) we use the formula as enumerated in table 1. In the mentioned formula Rf is the risk free rate of return where Rm is the current market rate. Rm-Rf represents the market premium. Beta measures the systematic risk (associated with the environment in which the entity operates) of the company in relation to the current market risk.
The company currently has debt through two resources i.e. through bank overdraft and an issuance of redeemable debt bond. For bank overdraft the cost of debt is the rate on which the company pays interest. For the redeemable bond, the cost of debt can be calculated as mentioned in Table 2. Since interest (Coupon x Face value of the debt) is the only cash flow, the IRR of the cash flows is the cost of the debt kd.