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TOPIC 4: COST OF CAPITAL answersQuestion 1Tanya Industries is planning to sell a new 12% bond maturing in 15 years at RM1, each. Each bond has a flotation charge of RM30. If the firm's tax rate is 34%, what is the approximate after-tax cost of new bonds?kd = $120 + ($1000 – $ 970 ) 15 ($1000 + $97 0...

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TOPIC 4: COST OF CAPITAL answers Question 1 Tanya Industries is planning to sell a new 12% bond maturing in 15 years at RM1,000 each. Each bond has a flotation charge of RM30. If the firm's tax rate is 34%, what is the approximate after-tax cost of new bonds?

kd = $120 + ($1000 – $ 970) 15 ($1000 + $970 ) 2 = $122 / $985 = 12.39% After-tax cost of new debt (Kd) = 12.39% (1-34%) = 8.18% Question 2 Yippee Jewelers is trying to determine its cost of debt. The firm has debt issue outstanding with 12 years to maturity that is quoted at net price RM1040. The issue makes annual payment and has embedded cost of 8% annually from par value. What is Yippee’s pre-tax cost debt? If the company’s tax rate is 35%, what is the after tax cost of debt? n=12 MV=1040

C=8 % x 1000= 80

T=35%

kd = $80 + ($1000 – $1040) 12 ($1000 + $1040) 2 = 7.52% After-tax cost of new debt (Kd) = 7.52% (1-35%) = 4.89%

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Question 3 Malaysian Corp plans to issue 25 year, 9% c o u p o n bond ( p a i d semiannually) with a flotation cost of RM12 per unit. Calculate the after tax cost of debt if the current market value for the bond is RM980. Tax rate is fixed at 28%.

n = 25x2 = 50 kd

C =9% x 1000 x ½ = 45

FV =12

MV =980 Net MV = 980-12= 968

= $45 + ($1000 – 968) 50 ($1000 + $968) 2 = 4.64% (semiannually) = 9.28% (annually)

After-tax cost of new debt (Kd) = 9.28% (1-.28) = 6.68%

Question 4 The Mountaineer Airline Company has consulted with its investment bankers and determined that they could issue new debt with a yield (before-tax) of 8%. If the corporate tax rate is 39%, what is the after-tax cost of debt to Mountaineer?

kd= 0.08 (1 – 0.39) = 0.0488 or 4.88% Question 5 Douglas Oil & Gas has an opportunity to sell new preferred stock for RM50 per share that pays a RM4.50 annual dividend. If each share has a RM2.50 flotation charge, what will be the cost of new preferred stock to the firm?

kps = $4.50/$47.50 = 9.47% Question 6

Gaga Publisher has an issue of preferred stock with RM48 stated dividend that just sold for net price RM726 per share. What is the publisher’s cost of preferred stock? kps

= 48/726 = 6.62% 2

Question 7

Guppy Inc. is planning to issue another series of preferred stock with RM52 of annual dividend that will be sold at RM737. The flotation cost is RM88. What is the cost of preferred stock? kps

= 52/(737-88) = 8.01%

Question 8 Use the following data for Textilease, Inc. to solve questions 8 Current market price per share The most current dividends per share Earnings per share Flotation costs per share for sale of new common stock Beta on the firm's common stock Expected return on the market Risk-free rate Interest rate on AAA bonds Firm's historical growth rate in dividends

RM40.00 RM2.50 RM6.00 RM3.00 0.95 14% 5% 10% 6%

a) If the firm expects its growth rate to continue, what is the cost of retained earnings using the constant growth model? b) What is the cost of new common stock, using the constant growth model? c) What is the cost of new common stock for Textilease, Inc., using the Capital Asset Pricing Model (CAPM)? a) Cost of retained earnings or internal equity:

Kcs = ($2.65 / $40) + 0.06 =12.63%

b) Cost of new common stock or external equity: Kcs = [$2.65 / ($40 - $3)] + 0.06 =13.16% c) Cost of new common stock by using CAPM formula = Krf + ß(Km –Krf) = 0.05 + 0.95(0.14 – 0.05) = 13.55%

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Question 9 Malta Berhad just issued a dividend of RM0.42 per share on its common stock. The company is expected to maintain a constant 6% growth rate in its dividend indefinitely. If the stock sells for RM6.50 a share (net price), what is the company’s cost of new common stock?

Ksc

= D1 + g NP0 = 0.42 (1.06) + 0.06 = 12.85% 6.50

Question 10 Assume that Teleko’s common stock has a beta of 1.2. If the risk-free rate is 4.5% and expected return on the market is 13%, what is Teleko’s cost of equity? Ksc

= krf + B (km – krf) = 4.5 + 1.2 (13 – 4.5) = 14.7%

Question 11 Martin Enterprise has compiled the following information about its capital structure and estimated costs of new financing: Source of Capital Book Value (RM) Market Value (RM) After-tax cost (%) Long-term debt 2,000,000 1,800,000 7 Preferred Stock 500,000 600,000 12 Common Equity 1,500,000 3,600,000 16 The company expects to have a significant amount of retained earnings available and does not expect to sell any additional common stock. a) What is the firm's WACC, using book value weights? b) What is the firm's WACC, using market value weights? a) WACC = 0.500 (0.07) + 0.125(0.12) + 0.375(0.16) = 11% b) WACC = 0.30(0.07) + 0.10(0.12) + 0.60(0.16) = 12.90% Question 12 Tut-tut Manufacturing has a target debt ratio of 35%. Its cost of equity is 18% and its before-tax cost of debt is 10%. If the tax rate is 30%, what is Tut-tut’s WACC? WACC = 0.35 [(10%) (1-.30)] + 0.65 (18%) = 14.15% 4

Question 13 Gaggle Internet, Inc. is evaluating its cost of capital under alternative financing arrangements. The corporate tax rate is 35%. In consultation with investment bankers, Gaggle expects to be able to: Issue new debt: • at par with a coupon rate of 8%. • investors expect an 8% return. • debt cost before tax is 8% Issue new preferred stock: • with a RM2.50 per share dividend • net price of RM25 a share. Utilise internal funds: • the market price of common stock is RM20.00 a share. • Gaggle expects to pay a dividend of RM1.50 per share next year. • Market analysts foresee a growth in dividends in Invest stock at a rate of 5% per year. Gaggle' marginal tax rate is 35%. a) If Gaggle raises capital using 45% debt, 5% preferred stock, and 50% common stock, what is Gaggle's cost of capital? b) If Gaggle raises capital using 30% debt, 5% preferred stock, and 65% common stock, what is Gaggle’s cost of capital?

kd= 0.08 (1 – 0.35) = 0.52 or 5.2% kps = $2.50 / $25 = 10% kcs = $1.50 / $20 + 5% = 7.5% + 5% = 12.5% a. WACC = [0.45 (0.052)] + [0.05 (0.10)] + [0.50 (0.125)] WACC = 0.0234 + 0.005 + 0.0625 WACC = 0.0909 WACC = 9.09% This means for every $1 Gaggle raises from investors, it must pay its investors almost $0.09 in return. b. WACC = [0.30 (0.052)] + [0.05 ( 0.10)] + [0.65 (0.125)] WACC = 0.0156 + 0.005 + 0.08125 WACC = 0.10185 WACC = 10.185% This means for every $1 Gaggle raises from investors, it must pay its investors almost $0.10 in return.

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Question 14 Peak Manufacturing Company has the following capital structure stated in book value terms: Source of Capital Bonds (RM1,000 par, 8.5% coupon) 3,000,000 Preferred stock (25,000 shares at RM20 500,000 par) Common stock (200,000 shares 200,000 outstanding at RM1 par)

RM

The firm's bonds are currently selling for RM965 per bond, the preferred stock for RM18 per share, and the common stock for RM40 a share. What is the market value of each source of capital and the current total value of the firm (total financing needed based on market value)? Bond $3mill /$1000 = 3,000 bonds x $965 = $2.895 mill Preferred Stock 25,000 shares x $18 = $450,000 Common stock 200,000 shares x $40 = $8 mill TOTAL = $11,345,000

Question 15 A firm currently has the following capital structure which it views as optimal. DEBT: RM 3,000,000 par value of 9 percent bonds outstanding with an annual before-tax cost of debt of 7.97 percent on a new issue. T he bonds currently sell for RM 1150 per RM 1000 par value. COMMON STOCK: 46,000 shares outstanding currently selling for RM 50 per share. The firm expects to pay a RM 5.00 dividend per share one year from now and is experiencing a 3.97 percent growth rate in dividends, which it expects to continue indefinitely. The corporate tax rate is 40 percent, and it expects to be able to finance all new projects with debt and internal common equity. i.

Define the term cost of capital.

The CoC is the rate that must be earned on an investment project if the project is to increase the value of the common stock’s investment.

ii.

Calculate the current total value of the firm (total financing needed based on market value)

BOND:

(RM3,000,000/RM1000) = 3,000 units 3,000 units X RM1150 = RM3,450,000 6

COMMON STOCK: 46,000 units X RM50 = RM2,300,000 CURRENT TOTAL VALUE = RM3,450,000 + RM2,300,000 = RM5,750,000

iii.

What is the proportion of debt in this firm’s capital structure? RM3,450,000 / RM5,750,000 = 60%

iv.

Calculate the after-tax cost of debt. AT = 7.97% X (1- 0.4) = 4.782%

v.

Calculate the cost of common stock. Kcs = (RM5/RM50) + 3.97% = 13.97%

vi.

What is the firm’s weighted average cost of capital (WACC)? (60% X 4.782%) + (40% X 13.97%) = 8.4572%

TRUE or FALSE 1)

The cost of capital is the minimum rate of return required by the investors supplying the funds.

2)

The cost of capital helps establish a benchmark return that the company must achieve to satisfy its debt and equity investors

3)

There are no free sources of permanent financing.

4)

The after-tax cost of debt is generally more expensive than the cost of common equity.

5)

Flotation costs increase the cost of issuing new securities.

6)

The cost of preferred stock is equal to the rate of return required by preferred stockholders multiplied by (1 - tax rate).

7)

The WACC is the sum of each specific cost of capital divided by the total number of different types capital.

8)

If a firm were financed entirely by bonds or other loans, its cost of capital would be equal to its cost of debt. Conversely, if the firm were financed 7

entirely through common or preferred stock issues, then the cost of capital would be equal to its cost of equity. 9)

Defining the cost of capital takes into account two general perspectives: the required rate of return of the lender and the weighted average cost of capital for the borrower.

10)

The default rate of return attached to a ‘risk free’ asset, such as a treasury bond. While nothing is completely risk free, these assets are as close to minimal risk as possible and represent the lowest practical rate of return.

11)

An additional amount of capital that changes the WACC is referred to as a break point. This is the point at which the cost of one of the sources of capital changes.

12)

Break Point = (Amount of Capital at which Sources Cost of Capital Changes) X (Proportion of New Capital Raised from the Source)

TRUE (T) or FALSE (F) 1) T 2) T 3) T 4) F 5) T 6) F 7) F 8) T 9) T 10) T 11) T 12) F

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