ABMF4024 BUSINESS FINANCE Tutorial 6(Cont.

) Answer November 10, 2010

Question 1
40% Debt; 60% Common equity; rd = 9%; T = 40%; WACC = 9.96%; rs = ?
WACC = (wd)(rd)(1 – T) + (wc)(rs)
0.0996 = (0.4)(0.09)(1 – 0.4) + (0.6)rs
0.0996 = 0.0216 + 0.6rs
0.078 = 0.6rs
rs = 13%.

Question 2
P0 = $30; D1 = $3.00; g = 5%; rs = ?
D1 $3. 00
a. rs = P0 + g = $30.00 + 0.05 = 15%.

b. F = 10%; re = ?
D1 $ 3 . 00
re = P 0 (1−F ) +g = $ 30(1−0 .10 ) + 0.05
$3 .00
= $27 .00 + 0.05 = 16.11%.

Question 3
D1 $2 .14
a. rs = P0 + g = $23 + 7% = 9.3% + 7% = 16.3%.

b. rs= rRF + (rM – rRF)b

= 9% + (13% – 9%)1.6 = 9% + (4%)1.6 = 9% + 6.4% = 15.4%.

c. rs = Bond rate + Risk premium = 12% + 4% = 16%.

d. Since you have equal confidence in the inputs used for the three approaches, an
average of the three methodologies probably would be warranted.
16 .3 %+15 . 4 %+16 %
rs = 3 = 15.9%.

Question 4
Debt = 40%, Common equity = 60%.
P0 = $22.50, D0 = $2.00, D1 = $2.00(1.07) = $2.14, g = 7%.
D1 $2.14
rs = P 0 +g= $22 .50 + 7% = 16.51%.
WACC = (0.4)(0.12)(1 – 0.4) + (0.6)(0.1651)
= 0.0288 + 0.0991 = 12.79%.
ABMF4024 BUSINESS FINANCE Tutorial 6(Cont.) Answer November 10, 2010

Question 5
a. rd = 10%, rd(1 – T) = 10%(0.6) = 6%.
D/A = 45%; D0 = $2; g = 4%; P0 = $20; T = 40%.
Project A: Rate of return = 13%.
Project B: Rate of return = 10%.
rs = $2(1.04)/$20 + 4% = 14.40%.

b. WACC = 0.45(6%) + 0.55(14.40%) = 10.62%.

c. Since the firm’s WACC is 10.62% and each of the projects is equally risky and as risky
as the firm’s other assets, MEC should accept Project A. Its rate of return is greater
than the firm’s WACC. Project B should not be accepted, since its rate of return is
less than MEC’s WACC.

Question 6
If the firm's dividend yield is 5% and its stock price is $46.75, the next expected annual
dividend can be calculated.
Dividend yield = D1/P0
5% = D1/$46.75
D1 = $2.3375.
Next, the firm's cost of new common stock can be determined from the DCF approach for
the cost of equity.
re = D1/[P0(1 – F)] + g
= $2.3375/[$46.75(1 – 0.05)] + 0.12
= 17.26%.

Question 7
a. Examining the DCF approach to the cost of retained earnings, the expected growth
rate can be determined from the cost of common equity, price, and expected
dividend. However, first, this problem requires that the formula for WACC be used
to determine the cost of common equity.

WACC = wd(rd)(1 – T) + wcrs

13.0% = 0.4(10%)(1 – 0.4) + 0.6(rs)
10.6% = 0.6rs
rs = 0.17667 or 17.67%.

From the cost of common equity, the expected growth rate can now be determined.

rs = D1/P0 + g
0.17667= $3/$35 + g
g = 0.090952 or 9.10%.

b. From the formula for the long-run growth rate:

g = (1 – Div. payout ratio)  ROE = (1 – Div. payout ratio)  (NI/Equity)
0.090952 = (1 – Div. payout ratio)  ($1,100 million/$6,000 million)
0.090952 = (1 – Div. payout ratio)  0.1833333
ABMF4024 BUSINESS FINANCE Tutorial 6(Cont.) Answer November 10, 2010

0.496104 = (1 – Div. payout ratio)

Div. payout ratio= 0.503896 or 50.39%.

Question 8
a. With a financial calculator, input N = 5, PV = -4.42, PMT = 0, FV = 6.50, and then
solve for I/YR = g = 8.02%  8%.

b. D1 = D0 (1 + g) = $2.60(1.08) = $2.81.

c. rs = D1/P0 + g = $2.81/$36.00 + 8% = 15.81%.

Question 9
a. rd(1 – T) = 0.10(1 – 0.3) = 7%.
rp = $5/$49 = 10.2%.
rs = $3.50/$36 + 6% = 15.72%.

b. WACC:
After-tax
Weighted
Component Weight  Cost =
Cost
Debt [0.10(1 – T)] 0.15 7.00% 1.05%
Preferred stock 0.10 10.20 1.02
Common stock 0.75 15.72
_11.79__
WACC =
13.86%

c. Projects 1 and 2 will be accepted since their rates of return exceed the WACC.

Question 10
a. If all project decisions are independent, the firm should accept all projects whose
returns exceed their risk-adjusted costs of capital. The appropriate costs of capital
are summarized below:

Required Rate of Cost of

Project Investment Return Capital
A $4 million 14.0% 12%
B 5 million 1.5 12
C 3 million 9.5 8
D 2 million 9.0 10
E 6 million 12.5 12
F 5 million 12.5 10
G 6 million 7.0 8
ABMF4024 BUSINESS FINANCE Tutorial 6(Cont.) Answer November 10, 2010

H 3 million 11.5 8

Therefore, Ziege should accept projects A, C, E, F, and H.

ABMF4024 BUSINESS FINANCE Tutorial 6(Cont.) Answer November 10, 2010

b. With only $13 million to invest in its capital budget, Ziege must choose the best
combination of Projects A, C, E, F, and H. Collectively, the projects would account
for an investment of $21 million, so naturally not all these projects may be accepted.
Looking at the excess return created by the projects (rate of return minus the cost of
capital), we see that the excess returns for Projects A, C, E, F, and H are 2%, 1.5%,
0.5%, 2.5%, and 3.5%. The firm should accept the projects which provide the
greatest excess returns. By that rationale, the first project to be eliminated from
consideration is Project E. This brings the total investment required down to $15
million, therefore one more project must be eliminated. The next lowest excess
return is Project C. Therefore, Ziege's optimal capital budget consists of Projects A,
F, and H, and it amounts to $12 million.

c. Since Projects A, F, and H are already accepted projects, we must adjust the costs of
capital for the other two value producing projects (C and E).

Required Rate of Cost of

Project Investment Return Capital

C $3 million 9.5% 8%+1%=

E 6 million 12.5 12%+1% = 13%

If new capital must be issued, Project E ceases to be an acceptable project. On the

other hand, Project C's expected rate of return still exceeds the risk-adjusted cost of
capital even after raising additional capital. Hence, Ziege's new capital budget
should consist of Projects A, C, F, and H and requires $15 million of capital, so $3
million of additional capital must be raised.