ABMF4024 Business Finance
Tutorial 6 Answer
23 December 2010
Question 1 a)
WACC=wdrd
(1-T) +wprp+wcrs Sources of capital that should be included when estimating Colemans i. Debt
WACC:
ii. Preferred stock iii. Common equity b) The component costs should be figured on an after-tax basis. of the firms stock, which we want to maximize, depends on after-tax cash flow and stockholders also look at after-tax cash flows c) The costs should be new (marginal) costs Cost of capital is used to make capital budgeting decisions/raise new capital
Value
Question 2 Market interest rate on Colemans debt = 5% x 2(semi-annual PMT) = 10% Component cost of debt = after-tax cost of debt = rd(1-T) = 10% (1 0.4) = 6%
n = 30 PV = 1153.72 F V = 1000 Coupon PMT = RM60
Question 3 Nominal cost of debt The rate quoted by bank, brokers or other financial Include number of compounding periods per year Effective annual cost Annual rate of interest actually being earned, as opposed to the quoted rate Will produce the same ending/future value if annual compounding had been used We
should use the nominal cost of debt
Cost of capital should be compounded yearly to be consistent with the CF Capital budgeting CF generally assumed to occur at the end of the year
Question 4 a) Component cost of preferred stock WACC=wdrd (1-T) +wprp+wcrs
Since preferred dividends are not tax deductible to the issuer, there is no need for a tax adjustment b) Corporations own most preferred stock, because 70% of preferred dividends are excluded from corporate taxation. Therefore. Preferred often has a lower before-tax yield than the before-tax yield on debt issued by the same company. The after-tax yield to a corporate investor and the after-tax cost to the issuer are higher on preferred stock than on debt.
ABMF4024 Business Finance
Tutorial 6 Answer
23 December 2010
Question 5 a) Reinvested
earn a return
earning are retain (opportunity cost)
Earning can be Paid out as dividend b)
Question 6 Coleman = constant growth stock
Question 7 Bond-yield-risk-premium
Question 8 Method
Estimate
CAPM
14.2%
DCF
13.8%
Kd+ RP
14.0%
Average
14.0%
Since the three methods produce relatively close results, so we decided to use the average, 14%, as our estimate for Colemans cost of common equity.
Question 9 The company is raising money in order to make an investment. The money has a cost, and this cost is based primarily on the investors required rate of return, considering risk and alternative investment opportunities. So, the new investment must provide a return at least equal to the investors opportunity cost. If
the company raises capital by selling stock, the company doesnt get all of the money that investors put up. For example, if investors put up $100,000 and a nd if they expect exp ect a 15% return on that $100,000 the $15,000 of profits must be generated. But if flotation costs are 20% (20,000), then the company will receive only $80,000 of the 100,000 investors put up. That $80,000 must then produce a $15,000 profit, or a 1580 rate of return versus a 15% return on equity rose as retained earnings.
ABMF4024 Business Finance
Tutorial 6 Answer
23 December 2010
Question 10 a) The first approach is to include the floatation costs as part of the projects up-front cost (project cost). This reduces the projects estimated return. The second approach is to adjust the cost of capital to include flotation costs. This is most commonly done by incorporating floatation costs in the DCF model. b)
Question 11 WACC
= 11.1%
Capital Structure Weights
X
Components Costs = Product
0.3
6%
1.8%
0.1
9%
0.9%
0.6
14%
8.4%
1.0
11.1%
Question 12
Firm cannot control Market conditions especially interest rates and tax rates However,
Firm can control The firms capital structure and dividend policy The firms investment policy. Firm with riskier projects generally have a higher
WACC.
* When market interest , investor require return so WACC * When tax rate , you have to pay more especially government tax for capital gain. Required return higher, means that issuer have to pay more.
ABMF4024 Business Finance
Tutorial 6 Answer
23 December 2010
Question 13 NO! The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC only represent the hurdle rate for a typical project with average risk.
Question 14
13.2%
