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2. Burgundy Inc. is financed through bonds and common stock. The bonds were
issued five years ago at a par value of $100 (total fund raised through bond
issuing is $5m). These bonds have a yield to maturity of 8.48% and are currently
trading at $105. The company’s shares have a market value of $4m, the return
on risk-free government bonds is 8% and the market risk premium has been 5%.
Burgundy’s shares have a lower than average risk and its historic beta is 0.85.
The corporate tax rate is 30%. Burgundy has a net asset figure of $3.5m showing
in its balance sheet.
a. Calculate the cost of debt and cost of equity capital.
b. Calculate the weighted-average cost of capital (WACC).
c. Should Burgundy use the WACC for all future projects? Explain your answer.
b. Mackenzie also has preferred stock outstanding that pays a $2 per share fixed
dividend. If this stock is currently priced at $25, what is Mackenzie’s cost of
preferred stock?
d. Mackenzie faces a 35% tax rate. Given the information in parts (a) to (d), and
your answers to those problems, what is Mackenzie’s WACC?
4.
a. Calculate the WACC of Pippin Ltd, using the following information:
Balance sheet extract
Liabilities
10% debentures ($100 par) $50,000,000
Shareholders’ funds
Paid-up capital – ordinary shares ($1) par $30,000,000
Additional information
February
FUNDAMENTAL OF FINANCIAL MANAGEMENT
6, 2017
Ordinary shares pay a dividend of 68 cents per year, and are expected to
pay the same dividend amount indefinitely.
Government bonds trade at 5% p.a. (this is an annual, not semi-annual,
yield).
The return on the market portfolio is 13%.
Pippin Ltd’s beta is 1.5.
Its debentures are priced at $106.
The current return on Pippin Ltd debentures is 2% p.a. above the
government bond rate (this is also expressed as an annual rate).
No company or personal taxes are levied.
The existing capital structure is unlikely to change.
b. Explain how and why Pippin Ltd might use the WACC you’ve just computed.
c. Ash Ltd, a privately held firm, is in the same industry as Pippin Ltd. Ash’s
operations are primarily in rural and regional areas. Ash is computing its
WACC, but feels that they should be using a higher beta than Pippin Ltd for
the following reasons:
Ash faces a higher risk or bush fires
Due to its rural locations, storm damage is more likely to affect the
company’s assets.
In your opinion, is the reasoning valid? Explain.
Year 0 1 2 3 4
Net Cash -20,000 2,000 5,000 5,000 15,000
Flow
Other information
BALANCE SHEET OF BIG COMPANY ($ 000’s)
Current Assets 10,000 Current Liabilities 8,000
Net Fixed 25,000 Long-term debt 10,000
Assets
Investments 15,000 Deferred taxes 3,000
Shareholders’ 30,000
equity
Total 50,000 Total 50,000
Long Term Debt consists of “junk” bonds issued at a face value of $7 million.
These pay interest semi-annually at a rate of 16% p.a. (compounding semi-
annually). They have 3 years to maturity and a coupon payment was made
yesterday. Long Term Debt also includes a secured liability to Huge Company
Ltd which currently sits in the books at $3 million. Interest is payable annually on
this at a fixed rate of 10% p.a. (which is also the current market rate for this
liability). The market yield on the junk bonds is 18% p.a. (compounding semi-
annually).
Compute the WACC of Big Company and determine the project’s NPV.