ABMF4024 Business Finance Tutorial 6 Answer 23 December 2010

Question 1
a) WACC=wd rd (1-T) +wp rp+wc rs
Sources of capital that should be included when estimating Coleman’s WACC:
i. Debt
ii. Preferred stock
iii. Common equity
b) The component costs should be figured on an after-tax basis.
 Value of the firm’s 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

Question 2
Market interest rate on Coleman’s debt = 5% x 2(semi-annual PMT) = 10%

Component cost of debt = after-tax cost of debt n = 30

= rd(1-T) PV = 1153.72
= 10% (1 – 0.4) FV = 1000
= 6% 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=wd rd (1-T) +wp rp+wc rs
Dp $ 10
r p= = =9.0 %
P p $ 111.10

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) CAPM =r s=r RF + ( r M −r RF ) b

CAPM =r s=7 % + ( 6 % ) 1.2=14.2%

Question 6
Coleman = constant growth stock
D1 D (1+ g)
DCF= + g= 0
P0 P0
D1 4.19(1.05)
DCF= + g= +0.05=13.8 %
P0 50

Question 7
Bond-yield-risk-premium
r s=r d + RP
r s=bond yield+ risk premium
r s=10 %+ 4 %
r s=14 %

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 Coleman’s 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 doesn’t get all of the money that investors put
up. For example, if investors put up $100,000 and if they expect 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 15⁄80 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 project’s up-front cost (project cost).
This reduces the project’s 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)
D0 (1+ g)
F e= +g
P0 (1−F)

$ 4.19(1.05)
F e= +5.0 %
$ 50(1−0.15)

$ 4.40
F e= +5.0 %
42.50

F e =15.4 %

Question 11
WACC = 11.1%
WACC=wd r d ( 1−T )+ w p r p +w c r s
WACC=0.3 (10 % ) ( 0.6 ) +0.1 ( 9 % )+ 0.6(14 % )
WACC=1.8 %+0.9 % +8.4 %
WACC=11.1 %
Capital Structure X Components Costs = Product
Weights
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 firm’s capital structure and dividend policy
 The firm’s 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
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
WACC=wd r d ( 1−T )+ w p r p +w c r s
WACC=0.4 % ( 12 % )( 1−0.4 % )+ 0.6 ( 17.27 % ) +0=¿ 13.2%

CAPM =r s=r RF + ( r M −r RF ) b
CAPM =7 %+ ( 6 % ) × 1.7=17.2%