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Problems

REVIEW QUESTIONS

Suggested answers to 10.1 What determines the value of an economic asset (as opposed to an asset that has
review questions appear value for reason of sentiment)?
in Appendix 3.
10.2 If we know the projected cash flows from loan notes and their current market value,
what approach would we take to deducing the cost of the loan notes?

10.3 Why does it seem likely that businesses have a ‘target’ gearing ratio?

10.4 What is wrong with using the cost of the specific capital used to finance a project as
the discount rate in relation to that project?

10.5 When calculating the weighted average cost of capital (WACC), should we use mar-
ket values or balance sheet values as the weights of debt and equity? Explain your
response.

10.6 When deducing the cost of equity through a dividend model, must we assume either
a constant level of future dividends or a constant level of growth of dividends? Explain
your response.

PROBLEMS

Sample answers to (Problems 10.1 to 10.4 are basic-level problems, whereas problems 10.5 and 10.6 are
problems marked with more advanced and may contain some practical complications.)
an asterisk appear in
Appendix 4. 10.1* Gregoris plc has some loan notes, currently quoted at £104 per £100 nominal value.
These will pay interest at the rate of 8 per cent p.a. of the nominal value at the end of
each of the next four years and repay £100 at the end of four years.

What is the cost of the loan notes? (Ignore taxation.)

10.2 Shah plc has a cost of equity of 17 per cent p.a. The business is expected to pay a
dividend in one year’s time of £0.27 per share. Dividends are expected to grow at
a steady 5 per cent each year for the foreseeable future.

What is the current price of one share in Shah plc?

10.3* Fortunate plc’s capital structure (taken from the balance sheet) is as follows:

£m

Ordinary shares of £0.50 each 8

10% preference shares of £1.00 5
Reserves 6
12% loan notes 10

The business pays corporation tax at the rate of 50 per cent and is expected to earn
a consistent annual profit, before interest and tax, of £9 million. ‘

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Chapter 10 • Cost of capital estimations and the discount rate

The current market prices of the business’s shares are:

Preference shares £0.65

Ordinary shares £0.80

The loan notes are irredeemable and have a market value of £100 per £100 nominal
value.

What is the weighted average cost of capital?

10.4 Doverdale plc has some convertible loan notes, with a current market value of
£109 per £100 nominal value, on which it will pay interest at the rate of 12 per cent on
their nominal value in one year’s time and then annually until conversion. In four years’
time the loan notes can be converted into ordinary shares at the rate of 25 shares
per £100 nominal value of loan notes.
The cost of the loan notes is 15 per cent p.a.

What value does the market believe that the shares will have in four years’ time, if it is
assumed that conversion will take place at that time? (Ignore taxation throughout.)

10.5* Da Silva plc’s shares are not traded in any recognised market. Its sole activity is
saloon car hire. It is financed by a combination of 2 million £0.50 ordinary shares and
a £1.5 million bank loan. Very recently, Mavis plc, a national car hire group, offered a
total of £5.5 million to acquire the entire equity of Da Silva plc. The bid failed because
the majority of shareholders rejected it since they wished to retain control of the
business, despite believing the offer to represent a fair price for the shares. The bank
loan is at a floating rate of interest of 10 per cent p.a. and is secured on various fixed
assets. The value of the bank loan is considered to be very close to its nominal value.
Da Silva plc’s current capital structure (by market value) represents what has been,
and is intended to continue to be, its target capital structure.
Da Silva plc’s management is in the process of assessing a major investment, to
be financed from retained earnings, in some new depots, similar to the business’s
existing ones. An appropriate cost of capital figure is required for this purpose. The
Gordon growth model has been proposed as a suitable basis for the estimation of the
cost of equity.
Recent annual dividends per share have been:

Year £

1 0.0800
2 0.0900
3 0.1050
4 0.1125
5 0.1250
6 0.1350
7 0.1450
8 0.1550

The business’s rate of corporation tax is expected to be 33 per cent p.a., for the fore-
seeable future.

(a) Estimate Da Silva plc’s weighted average cost of capital (WACC). (Ignore inflation.)
(b) What assumptions are being made in using the WACC figure that you have estim-
ated as the basis for the discount rate?

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Problems

10.6 Vocalise plc has recently assessed a new capital investment project that will expand
its activities. This project has an estimated expected net present value of £4 million.
This will require finance of £15 million. At the same time, the business would like to
buy and cancel the entire £10 million of 15 per cent loan notes, which are due to be
redeemed at par in four years’ time. It is estimated that the business will incur deal-
ing costs of £0.3 million in buying the loan notes. There are plans to raise most of the
necessary finance for the investment project and for buying the loan notes through a
one-for-one rights issue of equity at an issue price of £0.50 per share. The remaining
finance will come from the business’s existing cash resources. The issue will give rise
to administrative costs of £0.4 million.
None of these plans has been announced to the ‘market’, which is believed to be
semi-strong efficient.
Vocalise plc’s capital structure is as follows:

£m

Ordinary shares of £0.25 each 10

Reserves 14
24
15% loan notes 10
10% term loan 15
49

The current and likely future rate of interest for loans to businesses like Vocalise plc
is 10 per cent p.a. The business’s ordinary shares are currently quoted at £0.85 each.

(a) Estimate the theoretical share price following the announcement of the plans and
the issue of the new shares, assuming that the only influences on the price are
these plans. (Ignore taxation.)
(b) Why might the theoretical price differ from the actual one?

There are sets of multiple-choice questions and missing-word questions

‘ available on the website. These specifically cover the material contained in this
chapter. These can be attempted and graded (with feedback) online.

There are also five additional problems, with solutions, that relate to the material
covered in this chapter.

Go to www.pearsoned.co.uk/atrillmclaney and follow the links.

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