SGur-stupy PROBLEMS stl Lexton Ltd has an equity beta of 1.10, The market risk premium in South Africa is expected tobe 5% and the yield on government bonds is currently 7.5%. Lexton has issued bonds and its R100 par-value bond is currently trading at R94.50, The coupon rate is 8%. The maturity date is in five years’ time and the corporate tax rate is 28%. Interest is payable annually in arrears, The company has just paid the coupon interest for the current year, Required: (a) What is Lexton’s cost of equity, based on CAPM? (b) What is the after-tax cost of debt? (c) Lexton paid a dividend of RO.12 per share and the dividend per share is expected to grow at 7% indefinitely. The company’s share price is R2.30. What is the company’s cost of equity if we use the dividend growth model? (a) What is the weighted-average cost of capital (WACC) if the target debt-equity ratio is, 50%? (Use cost of equity as per CAPM.) $7.2 Rollon Ltd is a company that has issued corporate bonds ‘a par value of R100 and a coupon rate of 11%. The total Statement of Financial Position value of the bonds is R50m. ‘The company’s bonds are currently trading at a price of R103. Interest is payable annually in arrears. The maturity date is in four years’ time. The company has a target capital structure of 25% debt, 15% redeemable preference shares, 10% non-redeemable preference shares, and $0% in ordinary equity financing. Retained earnings and contributed capital amount to R100m. ‘The company has two types of preference shares in issue. There are 0.2m non-redeemable preference shares which were issued at R100 per share and there are 0.3m redeemable shares, which were also issued at R100 and are redeemable at R100 per share. The maturity date of redeemable preference shares is in four years’ time. Preference dividends are payable annually in arrears for both issues. Non-redeemable preference shares are currently priced at R107 and the redeemable preference shares are currently priced at R104. The coupon rates are 9% for each issue and coupon payments were recently paid. ‘The company’s beta is 1.20 and the risk-free rate is 8%. The market premium is expected to be 5.5%. The corporate tax rate is 28%, Required: (a) What is Rollon’s after-tax cost of debt? (b) What is the cost of the two types of preference shares? (©) What is the cost of equity? (d) What is the company’s weighted average cost of capital?Per FINANCIAL MANAGEMENT $73 Disks Ltd is a producer of music equipment. The company has identified five possible markets in respect of music preferences and has forecast their rates of return. They are as follows: Market Rate of return (%) Popuar 18% Bes 14% Mood musie: 13% Country Western 10% Light classic om ‘The company has designed special sound systems to enhance the qualities of each type of music. The cost of each system is R2.0m and each is a non-divisible investment. The current capital structure of Disks Ltd is considered to be optimal and will be maintained. At the end of the financial year the capital structure was: Capital structure Debentures (10%) R1 000 par value 30% Proterence shares (8%) R100 issue price 10% (Ordinary shares (1 milton issued) 20% Retained earnings 30% The company has a history and a stated policy of distributing 25% of its after-tax earnings as dividends. After-tax earnings were R4.00 per share, and estimated after-tax earnings for the next year are expected to reflect the historical growth of 10% p.a. The tax rate for the company is 28%. ‘The company is planningto finance the investment proposals by means of retainedearnings and other sources of finance. In this regard, it has been ascertained that new shares could be issued at the current market price of R50 per share; flotation costs would be 10% of the current market price. Furthermore, the company can raise R3.0m from the issue of non- redeemable debentures which have a par value of R.1 000 and a coupon rate of 8%, with no issue costs. The market-related interest rate for debentures in a similar risk class is 11%. The debentures would be issued at a discount to par value. It is estimated that a total amount of R5.0m could be raised from the issue of 10% preference shares and issue costs would be negligible. Preference shares of a similar risk class are presently offering yields of 10% p.a. Required: (a) Calculate the amount of retained earnings available to assist in the financing of the systems. (b) Calculate the cost of each capital component. (c) Determine the breaks in the weighted-average cost of capital schedule. (d) Calculate the weighted-average cost of capital between the break(s). (€) Indicate which system(s) should be chosen as an investment proposal and the total capital budget. (O Assume the current government 10-year bond yield is 7.5% and the market risk pre- mium is 5%. The company's beta is 1.05. What would be the cost of equity if the CAPM. approach is employed?Solutions to self-study problems $7.1 Solution 1, What is Lexton's cost of equity? The cost of equity using the Capital Asset Pricing, Model (CAPM) will be as follows: K,= Ry ¢ Beta (Market Risk Premium) Risk-free rate 7.50% Beta sane Beta x Market Risk Premium TW 3% __5.50% 13.00% 2. What is Lexton's after-tax cost of debt Cash flows 4 108, Yield to Maturity RR) sg tec calclr MP 108 [rem C34 50 PV, 5.8.8 PT, 100 £9. The pss WR br tin sang he pss 94 30 CH 8 Cy, CF), 8 CF}, 8 Cl, 108 CF), sen pees Sa TR YIM thas conto ets After tax cost of debt 43% 12% = 6.79% 3. What is Lexton's cost of equity, using the dividend growth model? Keo DiPy« Oe . . Kee DyPo+g : — 1% = 12.58% +4. What is Lexton’s cost of capital (WACO)? Debt 3333 6.79% Equity 66.67% 13.00% wacc 700.0% ete Eguay soon 1 Ade equa sXe the deb ai 6 14ND 0th the dee ai «0 5160 30$7.2 Solution 1, What ts Rollon’s after-tax cost of debt Cash lows 103.00 1 W 1 Yield Maury CR) ym a After tax cost of debt TOO Tm + 2. What Is Rollon’s cost of preference shares? Redeemable preference shares Cash flows 104.00 9 o 9 Yield to Maturny Non-redeemable preference shares Cost of non-redeemable preference shares = Dividend/Price Preference dividend 900 i Price 07.00 . Bane 3. What is Rollon's cost of equity? The cost of equity using the Capital Asset Pricing Model (CAPM) will be as follows; Kye Ry + Beta (Market Risk Premium) Riskefree rate 8.00% Baa inp Beta x Market Risk Premium 12 355 6.60% 14.00% 4. What is Rollon’s cost of eapital (WACC)? Debt 30 29% 72% 181% Prefs - redeemable x” 13% 780% -1AT% Prefs -non-redeemable 2» low Balm ORs Equity 100 50% 14.60) 7.30% WACC 200 Toor Tx 109$7.3 Solution 1, What is the retained earnings available for financing the systems? Cao 19S a es. Pao brs es.ors. amings & div pershare next yr 400 10 Ta 03s To 330 RE persare No.of ars kr Retained eaenings (RE) 330 1,000,000 5,500,000 2, What isthe cost of each capital component? Cost of etined earings 10. ke Di mate Cont of ew isu of iy Ke= DAP) - ee, Wen Cont of bens u% . om ‘ai pr tonne ie Cont of ference shares * vw00% 3. What are the breaks in the weighted average cost of capital sehedul 3,300,000 eine ening ica 3.300.000 owls new suit fap alge exces this amen Deters = BOI 000,000 - 5.00.00 Preernce share 0. 50,00,000 equity Debentures Preference shares ‘5, Which systems should be selected and what isthe capital budget? Select the systems that offer a return tha exceeds the cost of capital Capital Budget for Popular, Blues & Mood music 6,000,000 6, What bs the cost of equity I'we use the CAPM? ‘The cost of equity using the Capital Asset Pricing Model (CAPM) will be as follows: Ko Ry + Beta (Market Risk Premium) Risk-free ate ‘Bota x Market Risk Premium Tos Cost of Equity