(2015 S2) FINS1613 TutorialSlides Week09 RiskandReturn CostofCapital

o m
r r .c
b lu
t un
BUSINESS FINANCE a r
S m
FINS1613 i a
d v
r e
Tutorial
ha
S Week 09
s — Weighted Average Cost of Capital
i
if le
Risk & Return
RTBWJ: Chapter 12
hi s BDHFMF: Chapter 13
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RTBWJ: ROSS, TRAYLOR, BIRD, WESTERFIELD, & JORDAN — Essentials of Corporate Finance (3E Aus & NZ), &
BDHFMF: BERK, DEMARZO, HARFORD, FORD, MOLLICA, & FINCH — Fundamentals of Corporate Finance (2E Aus)
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 2
DISCOUNT RATES
So far in this subject we have come across several different discount rates
o m
Cost of Equity (re):
r r .c
• Also known as the required rate of return on equity (or on a share/stock)
b lu
n
• Typically calculated using CAPM, but an implied value can be worked out from the
Constant-Growth Dividend Model
a rtu
• Used for discounting equity cash flows (i.e. Dividends + other equity cash flows)
S m
Yield to Maturity (YTM):
v i a
• Also known as the required rate of return on a company’s bonds
e d
r
• Is the discount rate that sets the PV of a Bond’s future cash flows (coupons + face
a
S h
value) equal to its current price (such that investing in it is a zero NPV investment)
• Also used in today’s topic as the company’s pre-tax Cost of Debt (rd)
i s
i l
Weighted Average Cost
f e of Capital (WACC):
s
i level of risk for our firm. Allows us to find the NPV in Capital Budgeting.
• Used to discount
h
an individual PROJECT’s cash flows, assuming that project is of an
• AlsoT
AVERAGE
used to discount the firm’s overall FCFFs (i.e. the FCFs from ALL projects
combined), which will give you the levered value of the firm (i.e. VL from the M&M
topics)
3
FINS1613 — Peter Kjeld Andersen (2015-S2)
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WACC BASICSia&SWEIGHTS
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4
WACC
WEIGHTED AVERAGE COST OF CAPITAL
o m
Normally, the WACC equation that we will use in project evaluation is…
r r .c
(after-tax WACC in a classical taxation system) lu
n b
D Etu P
WACC  rd (1  t c ) r
 rea  rp
VL m VL VL
a S
i
• The cost of debt uses the YTM on thevcompany debt, NOT the coupon rate.
Important points about WACC:
e d
• The weights use the market values
a r of debt and ordinary equity, NOT the book
values.
S h
d
s
• Debt (r ) is typically cheaper
only because of thei interest tax shield, but also because it has a priority claim on
than preferred equity (r ) and ordinary equity (r ). Not
p e
the cash flowsif l+eassets on the firm. It is safer to lend money than to invest in equity,
i s
hence a lower
h
required return.
D T D E E
 
DEP DEP
market value
VL weights VL 5
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2012-S1 FINAL EXAM QUESTION 39
Q. For a typical firm with a given capital structure, which of the following is
o m
.c
correct? (Note: All rates are after tax. WACC: Weighted Average Cost of
Capital; rD: Cost of debt; rE: Cost of equity)?
r r
b lu
A. Your choices:
n
a) rD > rE > WACC
a rtu
b) rE > rD > WACC
S m
c) rE > WACC > rD
d) WACC > rE > rD v i a
e d
r
e) None of the above statements is correct
a
S h
Answer is c)
i s
f i l e
i
Equity is mores expensive than debt (thus r > r ).
h is a WEIGHTED AVERAGE of the two, thus falls in the middle.
E D
And theT WACC
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2014-S1 MFL QUESTION 1
Q. MV Corporation has debt with a market value of $95 million, ordinary equity
o m
.c
with a book value of $95 million, and preference shares worth $17 million
outstanding. Its ordinary shares trade at $45 each, and the firm has 5.5 million
r r
shares outstanding. What weights should MV corporation use in its WACC?
b lu
n
rtu
A. VL  MVFirm  MVDebt  MVEquity  MVPreference
 $95m   5.5m shares  $45/share   $17m  $359.5m

m a
a S
D MVDebt
 
$95m
 26.43% v i
VL MVFirm $359.5m
e d
a r
E MVEquity S h
5.5m shares  $45/share $247.5m
VL

MVFirm

i s $359.5m

$359.5m
 68.85%
if le $17m
P MVPreference
VL

hi
MVFirm
s   4.73%
$359.5m
T
7
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RTBWJ CHAPTER 12: PROBLEM 10
Q. Kerikeri Manufacturing has a target debt-equity ratio of 0.45. Its cost of equity
o m
.c
is 12%, and its cost of debt is 7%. If the tax rate is 35%, what is Kerikeri’s
WACC, given Kerikeri is operating under a classical tax system? r r
b lu
A. A debt-equity ratio of 0.45, or $0.45 of debt for every $1.00 of equity, translates n
to $0.45 of debt for every $0.45 + $1.00 = $1.45 of total financing.
a rtu
D $0.45
 
D

$0.45
S m
 31.03% debt
E $1.00 D  E $0.45  $1.00
v i a
E $1.00d
 
r e  68.97% equity
a
D  E $0.45  $1.00
h
S No preference
WACC  r (1  t ) isr  r
D E P share financing
e
in this question
l
d c e p
V V V
f
  7.0%(1
i  0.35)  0.3103  12.0%  0.6897 
i s
Th9.69%
8
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Manukau Boats Ltd has 5 million ordinary shares outstanding. The current
o m
.c
share price is $73, and the book value per share is $9. Manukau Boats also has
two bond issues outstanding. The first bond issue has a face value of $60
r r
million, a coupon rate of 7%, and sells for 98% of par. The second issue has
b lu
face value of $40 million, a coupon rate of 6.5%, and sells for 97% of par. The n
first matures in 20 years, the second in 12 years.
a rtu
Q. What are Manukau Boat’s capital structure weights on a book-value basis?
S m
A. BVEquity  # of shares  Book Value perishare
v a
e
 5,000,000 shares  $9/share d  $45, 000, 000
a r
BVDebt  FV Bond#1 FV
S h Bond#2
 $60, 000, 000 i s $40, 000, 000  $100, 000, 000


BVf i l e $45m
s
Equity
w Equity    31.03% equity
h
BVi  BV $45m  $100m
T
Equity Debt
BVDebt $100m
w Debt    68.97% debt
BVEquity  BVDebt $45m  $100m
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Q. What are Manukau Boat’s capital structure weights on a market-value basis?
o m
A. MVEquity  # of shares  Price per share
r r .c
 5,000,000 shares  $73/share  $365, 000, 000
b lu
n
rtu
MVDebt  Price Bond#1  Price Bond#2
a
 0.98  $60, 000, 000   0.97  $40, 000, 000   $97, 600, 000
m
MVEquity $365m
a S
w Equity 
MVEquity  MVDebt

v
$365m  $97.6m i
 78.90% equity
e d

MVDebt

$97.6m
a r  21.10% debt
w Debt
h
MVEquity  MVDebt $365m  $97.6m
S
i s
f il e
Q. Which are more relevant, the book- or market-value weights? Why?
hi s
A. The market value weights are more relevant because they represent a more
T
current valuation of the debt and equity.
10
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Koala Ltd has a target debt-equity ratio of 0.55. Its WACC under a classical tax
o m
.c
system is 8.1% and its tax rate is 30%.
Q. If Koala’s cost of equity is 11%, what is its pre-tax cost of debt? r r
D $0.55 D $0.55
b lu
A.     35.48% debt
n
rtu
E $1.00 D  E $0.55  $1.00

E

$1.00
m a
 64.52% equity
D  E $0.55  $1.00
a S
v i
e d
WACC  rd (1  t c )
D E
 re  rp
P
a r
V V
S hV
i s
8.1%   rd (1  0.30)  0.3548  11.0%  0.6452
f il e
h i
8.1% s
 11.0%  0.6452
T (1  0.30)  0.3548  4.0377%
r 
d
11
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Koala Ltd has a target debt-equity ratio of 0.55. Its WACC under a classical tax
o m
.c
system is 8.1% and its tax rate is 30%.
Q. If the after tax cost of debt is 3.8%, what is the cost of equity? r r
D $0.55 D $0.55
b lu
A.     35.48% debt
n
rtu
E $1.00 D  E $0.55  $1.00

E

$1.00
m a
 64.52% equity
D  E $0.55  $1.00
a S
v i
e d
D E
 re  rp
P
a r
V V
S hV
i s
8.1%  3.8%  0.3548   re  0.6452
f il e
h i
8.1% s
 3.8%  0.3548
T
r 
e
0.6452
 10.4646%
12
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o m
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S m
COST OFiaDEBT
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13
Jimmy’s Cricket Farm issued a 30-year, 6.5% half-yearly bond seven years ago.
o m
.c
The bond currently sells for 107% of its face value. The company’s tax rate is
35%.
r r
Q. What is the pre-tax cost of debt?
b lu
1  1  R   1 u n
 1  R  
 $1, 070  $32.5 r t
n 232
FV $1,000
P  C  n

0
 R  1  R 
m
n
a  R  1  R 
232
R  2.969% per six months (solved usingia

S
Excel... yay)
v
r  1  R   1  1  2.969%   1 d6.03% p.a. with annual compounding
e
2 2
d
r
adebt?
h
Doubling the 2.969% would give the YTM with semi-
Q. What is the after-tax cost of
S
annual compounding (i.e. an APR). But if we’re using
s 0.35) = 3.917%
our rd as part of WACC to discount annual cash flows,
= r (1 – tax) = 6.03%(1
d
i – you need it as an EAR (i.e. with annual compounding).
if le the pre-tax or after-tax cost of debt? Why?

Q. Which is more relevant,
A. The after-taxhi s
rate is more relevant because that is the actual cost to the
company. Ti.e. once you factor in the deduction of interest payments from your
tax.
14
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For the firm in Problem 7, suppose the book value of the debt issue is $105
o m
.c
million. In addition, the company has a second debt issue, a zero-coupon bond
with 10 years left to maturity; the book value of this issue is $75 million, and it
r r
sells for 62.5% of par.
b lu
n
rtu
Q. What is the total book value of debt?
A. BVDebt  $105, 000, 000  $75, 000, 000  $180, 000, 000
m a
a S
Q. The total market value? v i
e d
A. a r
MVDebt  107%  $105, 000, 000  62.5%  $75, 000, 000  $159,225,000
S h
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15
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Q. What is the after-tax cost of debt now?
o m
A. First, calculate the yield on the zero-coupon bond:
r r .c
 FV 
1
n
 $1,000 
1
b lu
n
10
rd(zero-coupon)   n   1   1
rtu

 P0   0.625  $1, 000 
 4.8122% p.a. w/ annual compounding
m a
a S
v i
Next, take a market-value weighted average of the two pre-tax costs of debt:
MVDebt(23yr bond) e d
MVDebt(zero-coupon bond)
rd   rd(23yr bond) 
a r  rd(zero-coupon)
MVDebt
S h MVDebt
 107%  $105, 000, 000
 i s   62.5%  $75, 000, 000
 6.0261%   

 4.8122% 

f il
$159,225,000 e   $159,225,000 
i
 5.6687%
h s p.a. w/ annual compounding
T
Lastly, make the weighted average cost of debt into the after-tax version:
= rd(1 – tax) = 5.6687%(1 – 0.35) = 3.6846%
16
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ANOTHER COST OF DEBT EXAMPLE
Jimmy’s Cricket Farm issued a thirty-year, 8% half-yearly bond seven years
o m
.c
ago. The bond currently sells for 108% of its face value. The company’s tax rate
is 30%.?
r r
Q. What is the pre-tax cost of debt?
b lu
1  1  R   n
1  1 uR  
 $1, 080  $40  rt
n 232
FV $1,000
P  C  n

 1  R   a R  1  R 
0 n 232
 R
S m
R  3.639% per six months (solved usingia Excel... yay)
v
r  1  R   1 1  3.639%   1  d
e
2 2
7.41% p.a. with annual compounding
d
a r
Q. What is the after-tax cost of
S h debt?
= r (1 – tax) = 7.41%(1
d
i s 0.30) = 5.187%
–
if le the pre-tax or after-tax cost of debt? Why?

Q. Which is more relevant,
A. The after-taxhi s
rate is more relevant because that is the actual cost to the
company. Ti.e. once you factor in the deduction of interest payments from your
tax.
17
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Q. ICU Window Ltd is trying to determine its cost of debt. The firm has a debt
o m
.c
issue outstanding with seven years to maturity that is quoted at 108% of face
value. The issue makes half-yearly payments and has an embedded cost of r r
6.1% annually. What is ICU’s pre-tax cost of debt?
b lu
n
A. 1  1  R  n 
P0  C  
FVn
 $1, 080  $30.5  a rt1u 1  R  72
 $1,000

 R  1  R 
n
S
 m R  1  R 
72
R  2.371% per six months (solved using Excel... yay) v i a

rd  1  R   1 
2 2 d
1  2.371%  re1  4.798% p.a. with annual compounding
h a
s S
Q. If the tax rate is 30%, what is its after-tax cost of debt?
i
if le – 0.30) = 3.359%
A. = r (1 – tax) = 4.798%(1
d
i s
Th
18
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MFL QUESTION FROM I CAN’T REMEMBER WHEN
Q. Laurel Limited has debt outstanding with a coupon rate of 5.9% and a yield to
o m
.c
maturity of 6.8%. Its tax rate is 35%. What is Laurel’s effective after-tax cost of
debt? r r
b lu
A. DON’T USE THE COUPON RATE. USE THE YIELD. n
rd 1  t c   6.8% 1  0.35 
a rtu
 4.42%
S m
i a
If you’re still confused about why, just think
v of the idea of zero-coupon bonds.
A company COULD issue zero-coupon
e d bonds.
a r
Does that mean its debt has no
S h cost?
NO! Because for every $1,000
i s point of time in the future, they’re only receiving
of Face Value they’re repaying on those bonds on
some discounted
e LESS THAN $1,000 ‘today’ when they issue them.
it’s maturity date at some
if lvalue
h
The rate that i s
determines how little/much money they receive for the $1,000
T to repay is the YTM (i.e. the required return of their lenders).
they promise
19
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o m
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S m
COST OF ORDINARYiaEQUITY / SHARES
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Th
20
COST OF EQUITY
Q. Compare and contrast the two different models that can be used for
o m
.c
estimating a company’s cost of equity capital—the dividend growth model
and the CAPM. Which model is preferred? Why? r r
b lu
CAPM
t un
Dividend Growth Approach
(from last class)
aDr D1
re  rRF  βi  rM  rRF  P   re  g
1
S m 0
r g e P0
v i a
Dividend growth model assumes growth
e d in perpetuity which is problematic.
r
aof the stock Beta, the risk free rate and the
The CAPM requires estimation
market premium. S h
i s
l
In practice, the most
f e
iand analysts are more likely to use the CAPM than the
difficult problem is using CAPM is finding the appropriate
market premium
h i
dividend growths model.
T
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Q. Hutt Ski’s ordinary shares have a beta of 1.15. If the risk-free rate is 3.9% and
o m
.c
the expected return on the market is 12%, what is Hutt Ski’s cost of equity
capital? r r
b lu
A. re  rRF  β  rM  rRF  n
 3.9%  1.15 12%  3.9%  a rtu
S m
 3.9%  9.315%  13.215%
v i a
e d
a r
S h
i s
f il e
hi s
T
22
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Q. Shares in Kelpie Industries have a beta of 0.9. The market risk premium is 7%,
o m
.c
and the risk-free rate is 3.5%. Kelpie's most recent dividend was $1.80 per
share and dividends are expected to grow at a 5% annual rate indefinitely. If r r
the share price is $47, what is your best estimate of Kelpie’s cost of equity?
b lu
n
A.
D0 1  g  D0 1  g  a rtu Dividend
P0 
re  g
 re 
P0
g
S m growth model
estimate
v i
$1.80 1  0.05 
a

e$47 d  0.05  0.090213  9.0213%
a r
re  rRF  β  RPM 
S h Both estimates of the cost of equity seem
reasonable. If we remember the historical return on
i s large capitalisation shares, the estimate from the
 3.5%  0.9  7%
f i l e CAPM / SML
estimate
CAPM model is about 2% lower than average, and
the estimate from the dividend growth model is
s
 3.5% i6.3%  9.8%
also about 3% lower than the historical average, so
Th
we cannot definitively say one of the estimates is
incorrect. Given this, you can just average the two.
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Q. Suppose Cactus Ltd just paid a dividend of $1.20 per share on its ordinary
o m
.c
shares. The company paid dividends of $0.85, $0.92, $0.99, and $1.09 per
share in the last 4 years. If the share price is $53, what is your best estimate of
r r
the company’s cost of equity capital using arithmetic and geometric growth
b lu
rates? n
A. g1 
D1  D0 0.92  0.85
  8.24%
a
8.24%  7.61%  10.10%  10.09%
rtu
D0 0.85 g arith 
4 S m
g2 
0.99  0.92
 7.61%  9.01%
v i a
0.92
e d 1
a r 4 
D 4  D0 1  g geo   g geo   D  4
 1
1.09  0.99
h
4
g3   10.10%
0.99
s S  D0 
i
1
 1.20  4
g4 
1.20  1.09
f il
 10.09%
e 
 0.85 
 1
i
1.09
h s  9.00%
T 1
or g geo  1  0.0824 1  0.07611  0.1010 1  0.1009    1 4
24
— Peter at A
Kjeld affordable
(2015-S2)
o m
.c
shares. The company paid dividends of $0.85, $0.92, $0.99, and $1.09 per
share in the last 4 years. If the share price is $53, what is your best estimate of
r r
the company’s cost of equity capital using arithmetic and geometric growth
b lu
rates? n
A. D0 1  g arith  D0 1  g arith  a rtu Dividend growth model
P0   re   gm estimate using arithmetic
re  g arith P0
a S arith
growth in dividends
v i
$1.20 1  0.0901

e d  0.0901  11.48%
a r $53
S h
D0 1  g geo  D0 1  g geo 
P0  is re   g geo
Dividend growth model
re  g geo
fil e P0
estimate using geometric
growth in dividends
i s $1.20 1  0.0900 
Th 
$53
 0.0900  11.47%
25
— Peter at A
Kjeld affordable
(2015-S2)
CGDM: ESTIMATING GROWTH RATES
ESTIMATING THE DCF GROWTH RATE
o m
.c
shares. The company paid dividends of $1.47, $1.62, $1.67 and $1.78 per
r r
share in the last four years. If the share price is $65, what is your best estimate
b lu
n
rtu
of the company’s cost of equity capital using arithmetic and geometric growth
rates?
g1 
D1  D0 1.62  1.47
  10.2% g 
1.67  1.62
m a
 3.09%
D0 1.47
2
1.62
a S
v i1.89  1.78
g3 
1.78  1.67
 6.59%
e d
g4 
1.78
 6.18%
1.67
a r
g arith  S h
10.2%  3.09%  6.59%  6.18%
 6.515%
i s 4
fil e 1 1
D4  D0 1  g geo   g geo   D4   1   1.89   1  6.484%

s
4 4
i
4
Th  D0   1.47 
1
or g geo  1  0.102 1  0.0309 1  0.0659 1  0.0618  1 4
26
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Kjeld affordable
(2015-S2)
CGDM: ESTIMATING GROWTH RATES
ESTIMATING THE DCF GROWTH RATE
o m
.c
shares. The company paid dividends of $1.47, $1.62, $1.67 and $1.78 per
r r
share in the last four years. If the share price is $65, what is your best estimate
b lu
n
rtu
of the company’s cost of equity capital using arithmetic and geometric growth
rates?
m a
g arith  6.515%
a S
D0 1  g  v i
1.89 1  0.06515
re,arith  g  d  0.06515  9.61%
P0
a re $65
S h
g geo  6.484% i s
f i1.89e
l 1  0.06484
hi s
re,geo  0.06484  9.58%
T $65
27
— Peter at A
Kjeld affordable
(2015-S2)
2015-S1 – ASS 09 – MFL QUESTION 2
Mackenzie Company has a price of $34 and will issue a dividend of $2.00 over
o m
.c
the next year. It has a beta of 1.3, the risk-free rate is 5.5%, and it estimates
the market risk premium to be 5.0%.
r r
Q. Estimate the cost of equity capital for Mackenzie?
b lu
n
A. From CAPM:
a rtu
r  r  β  r  r   5.5%  1.3  5.0%   12%m
e RF i m RF
a S
i
Q. Under the Constant-Growth DividendvModel, at what rate do you need to
e d
a
expect the company’s dividends r to grow to get the same equity cost of capital
S
as in the previous question?h
 g is
D D $2.00
P  r   12%   6.12%
if le P
1 1
A. 0 e
r ge $34 0
i s
Th
28
— Peter at A
Kjeld affordable
(2015-S2)
ADDITIONAL COST OF EQUITY EXAMPLE 1
A supermarket company, SMC, wants to calculate its cost of equity capital. The
o m
.c
company’s CFO has collected the following information: SMC’s current stock
price is $32 per share.
r r
The company has very recently paid a dividend of $2 per share, and its
b lu
n
rtu
dividend is expected to grow at a constant rate of 6% per year indefinitely.
The company’s corporate tax rate is 40%.
m a
Q. What is the SMC’s cost of equity capital?
D0 1  g  a S
A. P0  v i
re  g
e d
D0 1  g  r
2.00 1  0.06 
a
re 
P0
g 
S h
32
 0.06  12.625%
i s
f il e
hi s
T
29
— Peter at A
Kjeld affordable
(2015-S2)
ADDITIONAL COST OF EQUITY EXAMPLE 2
Ordinary shares of Lyon Gold Limited (LGL) are currently trading at $50 per
o m
.c
share, and is expected to pay a year-end dividend of $2.50 per share (i.e. D1 =
$2.50).
r r
The dividend is expected to grow at a constant rate of 4 percent per year.
b lu
n
rtu
The company has insufficient retained earnings to fund capital projects and
must, therefore, issue new ordinary shares (at the current price).
m a
The new shares have an estimated flotation cost of $3 per share.
a S
Q. What is the company’s cost of newly raised equity capital?
v i
D1
e d
A. re 
P0 1  F 
g
a r
$2.50 S h

 $3  i s
 0.04  9.32%
$50 1 
 $50 

f il e
hi s
T
30
— Peter at A
Kjeld affordable
(2015-S2)
o m
r r .c
b lu
n
a rtu
S m
COST OF PREFERENCE i a SHARES
d v
r e
ha
s S
i
if le
i s
Th
31
Q. Money Penny Bank has an issue of preference shares with a fixed dividend of
o m
.c
$6.25 that just sold for $108. What is the bank’s cost of preference shares?
D1 D1 r r
lu
Applying constant growth dividend
A. P   rp  g
b
0 model to a preference share’s value
rp  g P0
t un

$6.25
a
 0.00  0.057870 r
 5.7870%
$108
S m
v i a Since it’s a “fixed dividend”,
it’s just $6.25 per year, which
e d is a growth rate of g = 0%.
a r
S h
i s
f il e
hi s
T
32
— Peter at A
Kjeld affordable
(2015-S2)
o m
r r .c
b lu
n
a rtu
S m
WACC — PUTTING iIT a ALL TOGETHER
d v
r e
ha
s S
i
if le
i s
Th
33
Arammoana Farm Ltd has a target capital structure of 75% ordinary shares, 5%
o m
.c
preference shares, and 20% debt. Its cost of equity is 11.25%, the cost of
preference shares is 5.5%, and the cost of debt is 6.1%. The relevant tax rate is
r r
30%.
b lu
n
rtu
Q. What is Arammoana Farm’s WACC under a classical tax system?
A. WACC  rd (1  t c )
D E
 re  rp
P
m a
V V V
a S
  6.1%(1  0.30)  0.20  11.25%  0.75  5.5%  0.05  9.57%
v i
Q. The company CEO has approacheddyou about Arammoana Farm’s capital
structure. He wants to knowa r e
share financing, since it costsS h why the company does not use more preference-
less than debt. What would you tell the CEO?
i s
A. Since interest is tax
f i l edeductible and dividends are not, we must look at the after-
h i
tax cost of debt,s which is:
Hence, on an after-tax basis, debt is
r (1  tT)  6.1% 1  0.30   4.27%
d c
cheaper than the preference shares.
34
— Peter at A
Kjeld affordable
(2015-S2)
Q. Given the following information for Jackaroo Construction Ltd, find the WACC
o m
under a classical tax system. Assume the company’s tax rate is 30%.
• Debt: 8,500 bonds outstanding, with a 7.2% coupon, $1,000 par value, r .cyears to maturity,
selling for 118% of par; the bonds make half-yearly payments.
l u r 25
• Ordinary shares: 225,000 shares outstanding, selling for $87 perb

t un share; beta is 1.15.
share. a r
• Preference shares: 4.8% preference shares, 15,000 outstanding, currently selling for $98 per
• Market: 7% market risk premium and 3.1% risk-free

S m rate.
First, work out the costs of each type ofia

A.
v
r  r  β  RP   3.1%  1.15  7%d  11.15%
financing:
e RF M
r e
1  1  R   n
h a 1  1  R   252
 S
FV $1,000
P  C  $1,180  $36 
n

 is
1  R   1  R 
0 n 252
 R  R
R  2.9121% per f i l e
six months  r  1  2.9121%   1  5.91% p.a. compounded annually
2
h i s d
T
Unstated assumption that par
value of preference shares is
D $4.8
rp  1
g   0.00  0.048980  4.8980% $100, hence a $4.8 dividend.
P0 $98
35
— Peter at A
Kjeld affordable
(2015-S2)
A. Second, work out the weights:
MVEquity  # of shares  Price per share o m
r r .c
lu
 225,000 shares  $87/share  $19,575,000
MVDebt  # of bonds   % premium  Face Value per bond  n b
 8,500 bonds  118%  $1, 000   $10,030,000 a rtu
MVPreference  # of preference shares  Price per preference share S m
 15,000 shares  $98/share  $1,470,000v i a
e d
r
 MVFirm  $19,575,000  $10,030,000  $1,470,000  $31, 075, 000
a
h
 S
MVEquity $19.575m
w Equity 
MVFirm
e is$31, 075, 000  62.99% equity
MVf i l $10.030m
w Debt  is Debt
 32.28% debt
T h MV $31, 075, 000
Firm
MVPreference $1.470m
w Preference    4.73% preference shares
MVFirm $31, 075, 000 36
— Peter at A
Kjeld affordable
(2015-S2)
A. Finally, compute the WACC:
o m
D E
 re  rp
P
r r .c
V V V
b lu
t un
 5.9089%(1  0.30)  0.3228  11.1500%  0.6299    4.8980%  0.0473
a r
 8.5902%
S m
v i a
e d
a r
S h
i s
if le
i s
Th
37
— Peter at A
Kjeld affordable
(2015-S2)
Q. P Company has debt with a yield to maturity of 6.8%, a cost of equity of 12.7%
o m
.c
and a cost of preference shares of 10.1%. The market values of its debt,
preference shares and equity are $13.8 million, $2.9 million and $19.4 million, r r
respectively, and its tax rate is 32%. What is this firm’s Weighted Average Cost
b lu
n
rtu
of Capital?
A. MVFirm  $13.8m  $19.4m  $2.9m  $36.1m m a
a S
v i
D E
 re  rp
P
e d
V V V
a r
S h
$13.8m $19.4m $2.9m
 6.8%(1  0.32)
i s $36.1m  12.7%  10.1%
f i l e $36.1m $36.1m
i s
 1.7676%  6.8249%  0.8114%
Th9.40%
38
— Peter at A
Kjeld affordable
(2015-S2)
Growth Company’s current share price is $19.90 and it is expected to pay a
o m
.c
dividend per share of $1.10 next year. After that, the firm’s dividends are
expected to grow at a rate of 3.7% per year.
r r
Q. What is an estimate of the company’s cost of equity capital?
b lu
n
A. From the constant-growth dividend model:
a rtu
P0 
D1
 re 
D1
g
$1.10
 3.7%  9.23% S m
re  g P0 $19.90
v i a
e d
a r
Q. Growth company also has preference shares outstanding that pay a $2.00
S h
fixed dividend. If these shares are currently priced at $28.00, what is the
i s
company’s cost of preference shares?
f il e
A.
P0 
D1
hi s  rP 
D1
g
$2
 0%  7.14%
T
rp  g P0 $28
39
— Peter at A
Kjeld affordable
(2015-S2)
o m
.c
r r
Q. The company has existing debt issued 3 years ago with a coupon rate of 6.1%.
b lu
n
rtu
The firm just issued new debt at par with a coupon rate of 6.95%. What is
Growth Company’s pre-tax cost of debt?
m a
S
A. Debt that is trading at par has its coupon rate = its yield to maturity.
a
v i
Yield to maturity represents the company’s cost of debt. Therefore, 6.95%.
e d
r
Q. Growth Company has 4.7 million ordinary shares outstanding and 1.4 million
a
h
preference shares outstanding, and its equity has a total book value of $49.9
S
s
million. Its liabilities have a market value of $20.5 million. If Growth
i
f il e
Company’s ordinary and preference shares are priced as in parts A and B,
what is the market value of the company’s assets?
hi s
MVFirm  MVD  MVE  MVP  $20.5m   4.7m  $19.9   1.4m  $28.0   $153.23m
A.
T
40
— Peter at A
Kjeld affordable
(2015-S2)
o m
.c
r r
Q. The firm faces a 39% tax rate. Given our previous answers, what is the firm’s
b lu
n
rtu
WACC?
D E
A. WACC  rd (1  t c )  re  rp
V V V
P
m a
a S
 6.95%(1  0.39)
$20.5m
$153.23m
 9.23%
$93.53m
$153.23m
i
 7.14%
v
$39.2m
$153.23m
e d
 8.15%
a r
S h
i s
f il e
hi s
T
41
— Peter at A
Kjeld affordable
(2015-S2)
A retail coffee company is planning to open 105 new coffee outlets that are
o m
.c
expected to generate, in total, $16.6 million in free cash flows per year, with a
growth rate of 3.3% in perpetuity. The coffee company’s WACC is 9.9%.
r r
Q. What is the net present value of the expansion?
b lu
n
rtu
CF1
A. NPV0   Cost 0
rWACC  g
m a

$16.6m
 $??? a S
0.099  0.033 v i
e d
 $251.52m r
a about a startup cost at t=0, the NPV of the
h
In the absence of any information
S
i s
project is simply the PV of the future FCFs.
If you know how toebuild 105 coffee stores without spending any money, please
teach me  fi
l
i s
Th
42
— Peter at A
Kjeld affordable
(2015-S2)
RiverRocks Limited is considering a project with the projected free cash flows
o m
.c
shown below.
t=0 t=1 t=2
r r
t=3
FCFs –$49.4m
b
+$10.9m
+$20.6m +19.3m lu
n
The firm believes that, given the risk of the project,uthe
t
a r WACC is 12.5%.
appropriate approach to value the project. RiverRock’s
WACC method is the
Q. Should it take on this project? Why or whySnot?m

CF CFia CF
A. NPV  CF   1
v  3 3
1  r  e1 dr  1  r 
0 0 1 2 3
a r
WACC WACC WACC
 $49.4m  S
h  $19.3m  $20.6m
$10.9m
i s1  0.125 1  0.125 1  0.125
1 2 3
f i l e
 $9.99m
i s
The NPV ofhthe project is negative, so RiverRocks Limited should reject it.
T
43
— Peter at A
Kjeld affordable
(2015-S2)
ADDITIONAL WACC & NPV EXAMPLE 1
Suppose New Chocolate (NCT) is considering introducing a new product. The
o m
.c
firm believes that the product will become an instant success.
The cost of bringing the new product to market is $300 million, but NCT r r
expects first year incremental cash flows from it to be $35 million and will be
b lu
n
rtu
growing at 3% per year thereafter.
8%, equity accounts for 45% of its capital structure and the company’s taxm a
The company’s equity beta is 0.65, cost of equity is 12%, pre-tax cost of debt is
a S
rate is 30%.
v i
Q. What is the project’s net present value?
e d
A.
D
WACC  rd (1  t c )  re
E
a r
 8%  (1  0.30)  0.55  12%  0.45  8.48%
V V
S h
i s
CFle
NPV  f i  Cost1

$35m
 $300m  $338.686m
i
0
s
WACC g
0
0.0848  0.03
Th
44
— Peter at A
Kjeld affordable
(2015-S2)
Ophir Mining Corporation has:
o m
.c
6.3 million ordinary shares outstanding;
• 350,000 5.8% preference shares outstanding r r
• 150,000 7.1% half-yearly bonds outstanding, par value $1,000 each.
b lu
n
rtu
• The ordinary shares currently sell for $74 and have a beta of 1.09
The preference shares sell for $107; and the bonds have 20 years to maturity
m a
and sell for $109% of par.
a S
i
The market risk premium is 6.8%; government bonds are yielding 4.3%; and
v
Ophir Mining’s tax rate is 30%.
e d
a r
The book value of one preference share is $100.
S h
Q. What is the firm’s market value capital structure?
i s
il e
A. First, find the market value of each of the sources of capital:
f
MVEquity  # of shares  Price per share  6,300, 000  $74  $466,200,000
hi s
MVDebt T # of bonds   % of par  Face Value 
 150, 000  109%  $1, 000   $163,500,000
45
— Peter at A
Kjeld affordable
(2015-S2)
A. Continued…
MVPref  # of preference shares  Price of preference shares o m
 350, 000  $107  $37, 450, 000 r r .c
b lu
Then add them together to get the market value of the firm (aka MVFirm or VL):
n
MVFirm  MVEquity  MVDebt  MVPref
a rtu
 $466,200,000  $163,500,000  $37,450,000  $667,150,000
S m
i
Then find the weights of each source as a percentage of MVFirm:
MVEquity v a
w Equity  
$466,200,000
e d 69.88% equity
MV r
$667,150,000
Firm
a
MV S h
$163,500,000
 
s  24.51% debt
Debt
w Debt
MV
e i
$667,150,000
l
Firm
i
MV f $37,450,000
w Pref 
h
MVi s  Pref
$667,150,000
 5.61% preferred stock
T Firm
46
— Peter at A
Kjeld affordable
(2015-S2)
o m
r r .c
b lu
n
a rtu
m
S PROJECT RISK
WACC & ADJUSTINGiaFOR
d v
r e
ha
s S
i
if le
i s
Th
47
An all-equity firm is considering the following projects:
o m
.c
Project W X Y Z
Beta 0.80 0.90 1.10
r r
1.35
IRR 10.2%
b
11.4% 12.6% lu15.1%
n
The risk-free rate is 4%, and the expected return onuthe market is 12%.
t the firm’s 12% cost of
Q. Which projects have a higher expected return than a r
capital?
S m
v
A. The IRR for each project given in the tablei a IS the expected return.
So Y and Z have expected returnsethat d exceed the firm’s cost of capital of 12%.
a r
Q. Which projects SHOULD S
h
be accepted?
i s
A. Accept if IRR > thele
i required return coming from THAT PROJECT’s beta:
r  r  β  RP f   4%  β 12%  4% 
e RF
i s
hProject
M
TREQUIRED W
10.4%
X
11.2%
Y
12.8%
Z
14.8%
∴ Accept X (11.4% > 11.2%) and Z (15.1% > 14.8%) 48
— Peter at A
Kjeld affordable
(2015-S2)
o m
.c
Project W X Y Z
Beta 0.80 0.90 1.10
r r
1.35
IRR 10.2%
b 11.4% 12.6% lu 15.1%
n
t
Q. Which projects SHOULD be accepted? a r
S m
16.0%
v i a
A. Graphically we can depict these projects against the firm’s WACC & SML as:
d
We would have incorrectly
e
15.0% 15.1%
accepted Project Y
14.0%
a r comparing its 12.6%
h
expected return to the WACC
S
of 12%. We should reject it
13.0%
RETURN
as it’s less than the risk-
s
12.6%
12.0%
i adjusted required return of
if le
12.8%.
11.0% 11.4%
Similarly, we would reject
10.0%
i s 10.2%
Project X incorrectly as its
Th
expected return of 11.4% is
9.0% less than the WACC of 12%,
but we should accept it as
8.0%
it’s more than the required
0.6 0.8 1 1.2 1.4 return of 11.2%.
BETA 49
— Peter at A
Kjeld affordable
(2015-S2)
o m
.c
Project W X Y Z
Beta 0.80 0.90 1.10
r r
1.35
IRR 10.2%
b 11.4% 12.6% lu 15.1%
n
t
Q. Which projects SHOULD be accepted? a r
S m
16.0%
v i a
A. Graphically we can depict these projects against the firm’s WACC & SML as:
d
In the ZONE OF INCORRECT
e
15.0% 15.1%
ACCEPTANCE, the project is
14.0%
a r accepted because it exceeds
h
the firm’s WACC of 12%, but
S
should be rejected because it
13.0%
RETURN
falls below the SML.
s
12.6%
12.0%
i
if le
In the ZONE OF INCORRECT
11.0% 11.4%
REJECTION, the project is
10.0%
i s 10.2% rejected because it doesn’t
Th
exceed the firm’s WACC of
9.0% 12%, but should be accepted
because it falls above the
8.0% SML.
0.6 0.8 1 1.2 1.4
BETA 50
— Peter at A
Kjeld affordable
(2015-S2)
2012-S1 FINAL EXAM QUESTION 41
Q. The Barbie Company has an equal amount of low-risk projects, average-risk
o m
.c
projects, and high-risk projects. Barbie estimates that the overall company’s
WACC is 12 percent. This is also the correct cost of capital for the company’s
r r
average-risk projects. The company’s CFO argues that, even though the
b lu
company’s projects have different risks, the cost of capital for each project n
should be the same because the company obtains its capital from the same
a rtu
time? S m
sources. If the company follows the CFO’s advice, what is likely to happen over
v i a
A. Your choices:
e d
r
a) The firm will take on too many high-risk projects and reject too many low-
a
risk projects.
S h
i s
b) The firm will take on too many low-risk projects and reject too many high-
risk projects.
f il e
i s
c) Things will generally even out over time, and therefore, the risk of the firm
h
T
should remain constant over time
d) Statements a) and c) are both correct
e) Statements b) and c) are both correct Answer is a) 51
— Peter at A
Kjeld affordable
(2015-S2)
Q. RiverRocks (whose WACC is 11.0%) is considering an acquisition of Raft
o m
.c
Adventures (whose WACC is 14.0%). What is the appropriate discount rate to
use to evaluate the acquisition? Why?
r r
b lu
A. It is appropriate to use the discount rate for Raft Adventures of 14.0%, which
n
rtu
represents the riskiness of THAT particular investment.
a
The 14.0% WACC for the target company indicates that the investment is riskier
m
S
than the average investment for RiverRocks, which only has a 11% discount rate
a
for its firm.
v i
e d
a r
S h
i s
f il e
hi s
T
52
— Peter at A
Kjeld affordable
(2015-S2)
Q. RiverRocks’ purchase of Raft Adventures will cost $102 million, but will
o m
.c
generate cash flows that start at $15.0 million in one year and then grow at
4.0% per year forever. What is the NPV of the acquisition?
r r
b lu
A. CF1
n
rtu
NPV0   CF0
WACC  g CF
$15m m a

0.14  0.04
 $102m
a S
v i
 $150m  $102m  $48m
e d
a r
S h
i s
f il e
hi s
T
53
— Peter at A
Kjeld affordable
(2015-S2)
Q. RiverRock realises that it will have to raise the financing for the acquisition of
o m
.c
Raft Adventures by using new debt and equity. The firm estimates that the
direct issuing costs will come to $7.50 million. How should it account for these
r r
costs in evaluating the project?
b lu
A.
t un
Direct issuing costs (legal fees, investment banker / underwriter fees, etc.) occur
a r instruments (debt or
at time t = zero, at the time of issuance of your financing
equity).
S m
Although accounting standards may prefer i a to amortize these costs over future
years, the actual cash outflow occurs v
e d at t = 0. Remember, in finance, we care
about cash flow. r
aREDUCE our NPV (which is also a value at time t =
Essentially, these direct costs
S h
i s
0) by the amount of the cost.
So our new NPV is:
f i l e
NPV 0,New
h i s
 NPV  Direct issuance costs
0,Old
T  $48.00m  $7.50m  $40.50m

54
— Peter at A
Kjeld affordable
(2015-S2)
CoffeeStop primarily sells coffee. It recently introduced a premium coffee-
o m
.c
flavoured liqueur. Suppose the firm faces a tax rate of 36% and collects the
following information. It plans to finance 10% of the new liqueur-focused
r r
division with debt and the rest with equity. Assume a risk-free rate of 4.7%,
b lu
the cost of debt is 7.3% and a market risk premium of 8.1%. n
Beta
a r%tuEquity % Debt
CoffeeStop
S 0.59 m 96% 4%
0.23ia
BF Liqueurs
v
d division?
90% 10%
r e
Q. What WACC should it use for its liqueur
a
A. r  r  β  r  r   4.7%h 0.23  8.10%   6.563%
e RF i m
S
D is E
RF We use the beta of the
Barmania company because
if leV V
WACC  r (1  t )  r
d c e
it is better representative of
the systematic risk exposure
i s 1 9
h7.30%(1  0.36)  6.563%  6.37%
of our new liqueur division,
T
rather than the more risky
10 10 coffee business that our
firm’s overall beta reflects.
55
— Peter at A
Kjeld affordable
(2015-S2)
Your company has two divisions: One division sells software and the other
o m
.c
division sells computers through a direct sales channel, primarily taking orders
over the Internet. You have decided that Dell Computer is very similar to your
r r
computer division, in terms of both risk and financing. You go online and find
b lu
the following information: n
a
Dell’s beta is 1.16, the risk-free rate is 4.8%, its market value of equity is $66.8 rtu
m
billion, and it has $694 million worth of debt with a yield to maturity of 5.6%.
S
estimates. v i a
Your tax rate is 35% and you use a market risk premium of 5.9% in your WACC
e d
r
Q. What is an estimate of the WACC of your computer sales division?
a
A. e RF i m
S h
r  r  β  r  r   4.8%  1.16  5.9%   11.644%
RF
i s
WACC  r (1  til)e  r
D E
fd c e
is  0.35) $0.694  11.644% $66.8

V V
h5.6%(1
T $66.8  $0.694 $66.8  $0.694
 11.56%
56
— Peter at A
Kjeld affordable
(2015-S2)
Continued…
o m
.c
Q. If your overall company WACC is 12% and the computer sales division
represents 35% of the value of your firm, what is an estimate of the WACC for r r
your software division?
b lu
tun
A. WACCFirm  w Computer  WACCComputer  w Software
a r
 WACC Software
12%  0.35 11.56%  1  0.35   WACCSoftware S m

v i a
12%  0.35 11.56%
e d
WACCSoftware 
1  0.35 a r
 12.24%
S h
i s
f il e
hi s
T
57
— Peter at A
Kjeld affordable
(2015-S2)
o m
r r .c
b lu
n
a rtu
S m
DIVIDEND IMPUTATION i a & WACC
d v
r e
ha
s S
i
if le
i s
Th
58
CLASSICAL VS. IMPUTATION TAX
CLASSICAL VS. IMPUTATION TAX SYSTEMS
o m
.c
Q. Assume a company has taxable income (EBT) of $1.00 per share. Assume also
that the corporate tax rate is 30% on profits and the investor’s individual tax
r r
rate is 50%. Assume the company pays out all of it’s net income as a dividend
b lu
n
rtu
to the investors.
CLASSICAL TAXATION a
IMPUTATION TAXATION
m
If the individual had
paid tax on the
EBT $1.00
a S
EBT $1.00 company’s pre-tax
–TaxCorp –$0.30
v i –Tax –$0.30
profits, they would
have paid 50% of
d
Corp
re
$1.00 = $0.50.
Net Income = $0.70 Net Income = $0.70
Dividend
h a
$0.70 Dividend $0.70 But, the company has
S already paid $0.30,
is= $0.35
–TaxPersonal –$0.35 –TaxPersonal –$0.20 which means the
if le
individual only has to
Money Received Money Received = $0.50 pay the $0.20 extra.
i s Like the U.S. Like Australia.
Th
Personal tax is levied on your DIVIDENDS Personal tax is levied on the company’s
received from the company PRE-TAX PROFITS, but you can claim the
corporate tax to offset some of it.
59
— Peter at A
Kjeld affordable
(2015-S2)
CLASSICAL VS. IMPUTATION WACC EXAMPLE
Cobber Farm Ltd has a target capital structure of 70% ordinary shares, 5%
o m
.c
preference shares and 25% debt. Its cost of equity is 14%, the cost of
preference shares is 6% and the cost of debt is 7.5%. The relevant tax rate is
r r
30%.
b lu
n
rtu
Q. What is Cobber Farm Ltd’s WACC under both a classical tax system and an
imputation system?
D P E m a
A. WACCclassical  rd (1  t c )  rp  re
a S
v i V V V
e d
  7.5%(1  0.30)0.25   6%  0.05  14%  0.70  11.41%
a r
h
WACC   r (1  t )S    r (1  t )    r (1  t ) 
 D  P  E

imp
i s V 
d c
V 
p
V
c e c
if le
h s
i 
 7.5%(1  0.30)
2.5  
 6%(1  0.30)
0.5  
 14%(1  0.30)
7
10   10   10 
T
 8.38% ordinary + preferred
dividend payments are now
60
— Peter at A
Kjeld affordable
ndersen price,
no longer
email enquiries
(2015-S2)
double taxed
to rishabhk28@live.com
o m
r r .c
b lu
n
a rtu
S m
MULTIPLE CHOICE THEORY i a QUESTIONS
d v
r e
ha
s S
i
if le
i s
Th
62
OLD UNSW TUTORIAL MCQ #1
Q. Which of the following is not considered a capital component for the purpose
o m
.c
of calculating the weighted average cost of capital (WACC) as it applies to
capital budgeting?
r r
b lu
A. Your choices:
n
a) Long-term debt.
a rtu
b) Common stock.
S m
c) Accounts payable and accruals.
d) Preferred stock. v i a
e d
e) None of these answers
a r
S h
i s ANSWER IS C
if le + accruals are a non-interest bearing type of financing)

(accounts payable
i s
Th
63
— Peter at A
Kjeld affordable
(2015-S2)
Q. Which of the following factors in the discounted cash flow (DCF) approach to
o m
.c
estimating the cost of common equity is the least difficult to estimate?
r r
A. Your choices:
b lu
a) Expected growth rate, g.
n
b) Dividend yield, D1/P0.
a rtu
c) Required return, ks.
S m
d) Expected rate of return, .
v i a
d
e) All of the above are equally difficult to estimate.
e
r
a ANSWER IS B
S h
i s
f il e
hi s
T
64
— Peter at A
Kjeld affordable
(2015-S2)
Q. Wyden Brothers has no retained earnings. The company uses the CAPM to
o m
.c
calculate the cost of equity capital. The company's capital structure consists
of common stock, preferred stock, and debt. Which of the following events
r r
will reduce the company's WACC?
b lu
n
A. Your choices:
a) A reduction in the market risk premium. a rtu
S
b) An increase in the flotation costs associated with issuing new common
m
stock.
v i a
c) An increase in the company's beta.
e d
a r
d) An increase in expected inflation.
S h
e) An increase in the flotation costs associated with issuing preferred stock.
i s
f il e
hi s ANSWER IS A
T
65
— Peter at A
Kjeld affordable
(2015-S2)
Q. Conglomerate Inc. consists of 2 divisions of equal size, and Conglomerate is
o m
.c
100 percent equity financed. Division A's cost of equity capital is 9.8 percent,
while Division B's cost of equity capital is 14 percent. Conglomerate's
r r
composite WACC is 11.9 percent. Assume that all Division A projects have the
b lu
same risk and that all Division B projects have the same risk. However, the n
projects in Division A are not the same risk as those in Division B. Which of
a rtu
the following projects should Conglomerate accept?
S m
A. Your choices:
vi a We accept the project if it’s
a) Division A project with an 11 percent return.
e d return is greater than the cost
a
b) Division B project with a 12 percent return. r of capital for projects of that
S h
c) Division B project with a 13 percent return. level of risk.
is
d) Statements a and c are correct. i.e. division A project return
if le
must be greater than division A
e) Statements b and d are correct. cost of capital
i s
Th
ANSWER IS A If a company or division is
100% equity financed, then its
cost of capital must = its cost
of equity 66
— Peter at A
Kjeld affordable
(2015-S2)
Q. Which of the following statements is correct?
o m
A. Your choices:
r r .c
a) The cost of capital used to evaluate a project should be the cost of the
b lu
specific type of financing used to fund that project. n
b) The cost of debt used to calculate the weighted average cost of capital is
a rtu
the cost of new debt. S m
based on an average of the cost of debt already issued by the firm and
v i a
c) One problem with the CAPM approach in estimating the cost of equity
e d
capital is that if a firm's stockholders are, in fact, not well diversified,
a r
beta may be a poor measure of the firm's true investment risk.
S h
d) The bond-yield-plus-risk-premium approach is the most sophisticated
i s
and objective method of estimating a firm's cost of equity capital.
f il e
e) The cost of equity capital is generally easier to measure than the cost of
i s
debt, which varies daily with interest rates, or the cost of preferred stock
h
T
since preferred stock is issued infrequently.
ANSWER IS C 67
— Peter at A
Kjeld affordable
(2015-S2)
A company has a computer division and a restaurant division.
o m
.c
Stand-alone restaurant companies typically have a cost of capital of 8 percent,
while stand-alone computer companies typically have a 12 percent cost of r r
capital.
b lu
n
rtu
The restaurant division has the same risk as a typical restaurant company, and
its computer division has the same risk as a typical computer company.
m a
Consequently, they estimate that its composite corporate cost of capital is 10
a S
percent.
v i
d
The company's consultant has suggested that they use an 8 percent hurdle
e
r
rate for the restaurant division and a 12 percent hurdle rate for the computer
a
division.
S h
s
However, they have chosen to ignore its consultant, and instead, choose to
i
f il e
assign a 10 percent cost of capital to all projects in both divisions.
hi s
Q. Which of the following statements is most correct?
T
68
— Peter at A
Kjeld affordable
(2015-S2)
A. Your choices:
o m
a) While Kemp's decision to not risk adjust its cost of capital will lead it to
accept more projects in its computer division and fewer projects in its r r .c
restaurant division, this should not affect the overall value of the company.
b lu
n
rtu
b) Kemp's decision to not risk adjust means that it is effectively subsidizing its
a
restaurant division, which means that its restaurant division is likely to
m
become a larger part of the overall company over time.
a S
i
c) Kemp's decision to not risk adjust means that the company will accept too
v
d
many projects in the computer business and too few projects in the
e
r
restaurant business. This will lead to a reduction in the overall value of the
a
company.
S h
i s
d) Statements a and b are correct.
il e
e) Statements b and c are correct.
f
hi s
T ANSWER IS C
69
— Peter at A
Kjeld affordable
(2015-S2)

(2015 S2) FINS1613 TutorialSlides Week09 RiskandReturn CostofCapital

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o m

 $95m   5.5m shares  $45/share   $17m  $359.5m

 $60, 000, 000 i s $40, 000, 000  $100, 000, 000

R  2.969% per six months (solved usingia

if le the pre-tax or after-tax cost of debt? Why?

if le the pre-tax or after-tax cost of debt? Why?

R  2.371% per six months (solved using Excel... yay) v i a

D4  D0 1  g geo   g geo   D4   1   1.89   1  6.484%

e d is a growth rate of g = 0%.

• Ordinary shares: 225,000 shares outstanding, selling for $87 perb

• Market: 7% market risk premium and 3.1% risk-free

First, work out the costs of each type ofia

Q. Should it take on this project? Why or whySnot?m

as it’s less than the risk-

falls below the SML.

T  $48.00m  $7.50m  $40.50m

is  0.35) $0.694  11.644% $66.8

12%  0.35 11.56%  1  0.35   WACCSoftware S m

S already paid $0.30,

i s Like the U.S. Like Australia.

if le + accruals are a non-interest bearing type of financing)

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