ACC00152 Business Finance Topic 6 Tutorial Answers

1.

Problem 7, page 391 of the textbook.

Using the Capital Asset Pricing Model, Steadys cost of equity capital is: 6% + 0.20 x 7% = 7.4%.

2. Humble Manufacturing is interested in measuring its overall cost of capital. Current investigation has gathered the following data. The firms tax rate is 30 per cent. The target capital structure is 40% debt, 15% preference capital and 45% ordinary equity.

Debt: The firm can raise an unlimited amount of debt by selling 10 per cent, 10-year bonds on which annual interest payments will be made. Bonds would be sold at par.

Preference capital: The firms publicly traded preference shares pay a dividend of 11 per cent of their $10 par value. The preference shares are currently trading for $11.

Ordinary equity: The firms ordinary equity is currently selling for $8.00 per share. The firm expects to pay cash dividends of $0.60 per share in the coming year. The firms dividends have been growing at an annual rate of 6 per cent, and this rate is expected to continue in the future.

(a)

Calculate the cost of each source of financing.

Cost of debt:

The debt yield will be the same as the coupon at issue if the bonds sell at par value. So, there is no need to calculate the yield to maturity in this question. The before-tax cost of debt is 10%. The after-tax cost of debt is 10%(1 0.3) = 7%. The after-tax cost of debt needs to be calculated because interest is taxdeductible, reducing the cost of debt.

Cost of Preference Shares: Dividend = 0.11 x par value = 0.11 x $10 = $1.10 rP = Div/P0 = $1.10/11 = 10%

Cost of Ordinary Equity: No beta provided so we cant use SML approach. We have all the information needed for the dividend growth model approach: rE = Div1/P0 + g = $0.60/$8 + 0.06 = 0.075 + 0.06 = 0.135 = 13.5%

(b)

Calculate the firms WACC. rE E% + rP P% + rD (1 TC)D% = = = 0.135 x 45% + 0.10 x 15% + 0.10(1 0.3)40% 6.075% + 1.5% + 2.8% 10.375%

rWACC =

So the WACC for this company is, rounded, 10.4%.

(c)

Can this WACC be used to evaluate all the companys capital budgeting projects?

The WACC of 10.4% can be used as the discount rate in evaluating Humbles capital budgeting projects (eg calculating NPV) as long as the projects are of similar risk to Humbles usual projects. If they are much riskier or much less risky, an adjustment should be made up or down respectively, or some other method of calculating a discount rate (eg pure play approach) used.