講義教程講稿e4 the cost of capital

ThecostofcapitalRisk-returnrelationshipThemainprincipleisthatthehighertheriskfacedbytheinvestor,thehigherthereturntheywillexpecttobepaid;thisistherisk-returnrelationship.CreditorIntheeventofa beingunabletopayitsdebtsandgoingintoliquidation,thereisan inwhichithastorepayitscreditorsandinvestors.Increasing

CreditorswithafixedCreditorswithafloatingUnsecuredPreferenceOrdinaryAccordingtothecreditorhierarchy,listthefollowingfromhighrisktolowrisk:OrdinarysharePreferenceshareTradeBankloanwithfixedandfloatingDiscusswhythecostofequityKeisgreaterthanthecostofdebtKd.(5marks)Thecostofequityisthereturnrequiredbyordinaryshareholders(equityinvestors),inordertocompensatethemfortheriskassociatedwiththeirequityinvestment,i.e.theirinvestmentintheordinarysharesofa Iftheriskofaninvestmentincreases,thereturnexpectedbytheinvestoralsoincreases.Iftheriskofa therefore,itscostofequityalsoincreases.Ifa isliquidated,theorderinwhichtheclaimsofcreditorsaresettledisafactorindeterminingtheirrelativerisk.Theclaimsofprovidersofdebtfinance(debtholders)mustbepaidoffbeforeanycashcanbedistributedtoordinaryshareholders(theowners).Theriskfacedbyshareholdersistherefore thantheriskfacedbydebtholders,andthecostofequityisthereforethanthecostofInterestondebtfinancemustbepaidbeforedividendscanbepaidtoordinaryshareholders,sotheriskfacedbyordinaryshareholdersisgreaterthantheriskfacedbydebtholders.Dividendgrowthmodel Ifthe isexpectedtobe amount,thepresentvalueoffuturedividendsisaperpetuity.scalculatedbythewhereP0isthecurrentmarketprice(exd0isthecurrentnetkeisthecostofequityistheexpectedannualgrowthindividend2014/12Q19 hasjustpaidanordinarysharedividendof32·0centsandisexpectedtopayadividendof33·6centsinoneyear’stime.ThehasacostofequityofWhatisthemarketpriceofthe ’ssharestothenearestcentonanexdividendbasis?2014/12Q15Whichofthefollowingstatementsis/areAnincreaseinthecostofequityleadstoafallinshareInvestorsfacedwithincreasedriskwillexpectincreasedreturnasThecostofdebtisusuallylowerthanthecostofpreference21and32and31,2and2016/12Q24Indicate,byclickingontherelevantboxes,whetherthefollowingareassumptionsthataremadebythedividendgrowthmodel?AnswerAllthreeareassumptionsmadebythedividendgrowthGrowthrateThereare thatyouneedtoknow,buttheexaminermaygiveyoutherateintheexam.UseUsecurrentre-investmentUsehistoricEstimatingfuturedividendIfusingthecurrenttheformula

approach–notethatisgivenintheGordon'sgrowthapproximationWheregistheannualgrowthrateindividendsistheproportionofprofitsthatareistherateofreturnonnewIfa retains40%ofitsearningsforcapitalinvestmentprojectsithasidentifiedandtheseprojectsareexpectedtohaveanaveragereturnof20%:g=br=Ex historicgrowthGGCohasacostofequityof25%.Ithas4millionsharesinissue,andhasdoneformanyyears.Itsdividendpaymentsintheyears20X9to20Y3wereasfollows.EndofDividendsareexpectedtocontinuetogrowatthesameaveragerateintothefuture.,Accordingtothewhatshouldbethesharepriceatthestartof20Y4?,Answer20X9to20Y3covers4yearsof=(423,000×1.178)/(0.25–0.178)=$6,920,750for4million=$1.73perEx-cumdividendshareprice2016/12CarpCothatitwillpayanannualdividendequalto55%ofearnings.Itsearningspershareis$0.80,andithastenmillionsharesinissue.ThereturnonequityofCarpCois20%anditscurrentcumdividendsharepriceis$4.60WhatisthecostofequityofCarpAnswer Dividendtobepaid=0.80×0.55=$0.44pershareRetentionratio=100%-55%=45%Dividendgrowthrate=45%×20%=9%peryearKe=(0.44×1.09)/（4.60–0.44）+0.09=20.5% 才能確定的價值。例 例 2016/3CantCohasacostofequityof10%andhasforecastitsdividendsasfollows:Currentyear:NodividendYear1:NodividendYear2:$0.25perYear3:$0.50pershareandincreasingby3%peryearinsubsequentWhatisthecurrentsharepriceofCantCousingthedividendvaluationmodel? (2CAPMPortfoliotheoryPortfoliotheorysuggeststhatinvestorscanreducethetotalriskontheirinvestmentsbydiversifyingtheirportfolioofinvestments.Becauseeachinvestmentisexposedtodifferentrisks,investorsshouldconsiderhowthevalueofeachoftheirinvestmentschangesinrelationtoeveryotherinvestmentwhenmakingnewinvestments.SystematicriskThetotalriskinvolvedinholdingsecuritiesdividesintoriskspecifictoandriskduetovariationsinmarketactivityUnsystematicriskcanbediversifiedaway,whilesystematicormarketriskcannot.WhichofthefollowingbestdescribessystematicpTheriskassociatedwithinvestinginpThediversifiableriskassociatedwithinvestinginpTheresidualriskassociatedwithinvestinginawell-diversifiedpUnsystematicriskcanbediversifiedImplicationsforinvestmentsIfaninvestorholdsa ofallthestocksandsharesonthestockmarket,theywillincursystematicriskwhichisexactlyequaltotheaveragesystematicriskinthestockmarketasawhole.willtothismarketaverage.SomeshareswillbelessriskyandsomewillbemoreriskythanthestockmarketBetaSomesharesareverysensitivetostockmarketdownturns.Commercialdatabasesmonitorthesensitivityoffirmstoastockmarketdownturnbycalculatingtheaveragefallinthereturnonashareeachtimethereisa1%fallinthestockmarketasawhole;thisiscalledaIncreasingsystematicbeta<beta=beta>share<averageshareshare>averageKe<Ke=Ke>Thecostofequity–usingtheTheCAPMisshownonyourformulasheetE(ri)=Rf+β(E(Rm)-RfE(ri)=expectedreturnβ=thebetaofthe

E(Rm)=expectedmarketRf=the rateof(E(Rm)-Rf)=marketpremiumorriskCostof,Havingworkedouttheriskofa ,by CapitalAssetPricingModelgivesaformulaforcalculatingtherequiredreturniethecostofequity.,LectureexampleIfthereisamarketreturnof12%,andtherisk- rateis4%(i.e.thereisariskpremiumof8%)whatistherequiredrateofreturnonasharewithanequitybetaof1.6?whatisthecostofequityiftheequitybetaofashareisUsethebetaofthe ;1.6Ke=4+(8×1.6)=16.8%UsethebetaofKe=4+(8×0.8)=DGM&CAPMDiscusswhetherthedividendgrowthmodelorthecapitalassetpricingmodelshouldbeusedtocalculatethecostofequity.DGM.Thedividendgrowthmodelcalculatestheapparentcostofequityinthecapitalmarket,providedthatthecurrentmarketpriceoftheshare,thecurrentdividendandthefuturedividendgrowthrateare.Whilethecurrentmarketpriceandthecurrentdividendarereadilyavailable,itisverydifficulttofindanaccuratevalueforthefuturedividendgrowthrate.Acommonapproachtofindingthefuturedividendgrowthrateistocalculatetheaveragehistoricdividendgrowthrateandthentoassumethatthefuturedividendgrowthratewillbesimilar.Thereisnoreasonwhythisassumptionshouldbetrue.Thecapitalassetpricingmodeltendstobepreferredtothedividendgrowthmodelasawayofcalculatingthecostofequityasithasasoundtheoreticalbasis,relatingthecostofequityorrequiredreturnofwell-diversifiedshareholderstothesystematicrisktheyfacethroughowningthesharesofa However,findingsuitablevaluesforthevariablesusedbythecapitalassetpricingmodel(risk- rateofreturn,equitybetaandequityriskpremium)canbedifficult.Ex-AssumptioinWhichofthefollowingassumptionsisnotrequiredwhenusingthecapitalassetpricingmodeltoestimatethecostofequityforprojectpEfficientcapitalpWelldiversifiedpFutureperiodsareconsistentwiththepCompaniesarewellAFM-DiversifytoreduceriskCandiversificationbeachievedmoreefficiently levelor?Obviouslyindividualinvestorscandiversifymuchmorecheaplythancompaniescan.Alltheyhavetodoisbuysharesincompaniesindifferentindustries,whereascompanieshavetogothroughlong,complicatedandexpensiveprocessesinordertoacquireothercompanies.Therearetwoexceptions:Ownersofprivatefirmswithallormostoftheirwealthinvestedinthefirm.Theownerisexposedtoalltheriskthereforethereisagreatercasefordiversification.Incumbentmanagerswhohavelargeamountsoftheirwealthinvestedinthefirm.Ifthesemanagersdiversifythroughacquisition,theywillreducetheirexposuretototalrisk.Thisopensupotherargumentsastowhetherthesemanagersareactinginthebestinterestsoftheothershareholders,iftheothershareholdersdoholdwelldiversifiedportfoliosofothershares.Ex-EfficientcapitalmarketsAsecurity'srequiredreturncanbepredictedusingtheCAPMusingtheformula:rj=rf+βj(rm-SecurityXhasabetavalueof1.6andprovidesareturnof12.0%SecurityYhasabetavalueof0.9andprovidesareturnof13.0%SecurityZhasabetavalueof1.2andprovidesareturnof13.2%TheriskreturnisWhatdoesthisinformationindicateaboutthepricingofsecuritiesX,Y?Fillinthegapsinthestatementsbelow.SecurityXis......SecurityYChoosefromthefollowing:Underpriced/overpricedSecurityXis SecurityYisIfsecurityZiscorrectlypriced,itsactualreturnwillbethereturnpredictedbyCAPM.13.2=6+1.2(Rm-7.2/1.2+6=Rm=SecurityXhasabetavalueof1.6andshouldprovideareturnof61.6(12-6)=SecurityYhasabetavalueof0.9andshouldprovideareturnof6+0.9(12-6)=11.4%SecurityXdoesnotgiveahighenoughreturn,soisoverpriced.SecurityYgivestoohighareturn,soisunderpriced.Variables1 Variables-Beta BondpriceandyieldDiscountedcashflowtechniquescanbeusedtovalueirredeemabledebt,redeemabledebt,convertibledebtandpreferenceBondvaluation-Howmuchwouldaninvestorpaytopurchaseabondtoday,whichisredeemableinfouryearsforitsparvalueorfacevalueof$100andpaysanannualcouponof5%ontheparvalue?Therequiredrateofreturn(oryield)forabondinthisriskclassis4%.YTM-Abondpayingacouponof7%isredeemableinfiveyearsatpar($100)andiscurrentlytradingat$106.62.Theinternalrateofreturnapproachcanbeusedtoobtainr.Sincethecurrentpriceishigherthan$100,rmustbelowerthan7%.The5.46%isthe ofthebond. istherateofreturnatwhichthesumofthepresentvaluesofallfutureestreamsofthebond(interestcouponsandredemptionamount)isequaltothecurrentbondEx-2015/06Q10 hasinissueloannoteswithanominalvalueof$100each.Interestontheloannotesis6%peryear,payableannually.Theloannoteswillberedeemedineightyears’timeata5%premiumtonominalvalue.The oftheis7%perWhatistheexinterestmarketvalueofeachloan 100*6%*(P/A,7%,8)+105*(P/F,7%,=6*5.971+105*Ex-2014/12Q9 has7%loannotesinissuewhichareredeemableinsevenyears’timeata5%premiumtotheirnominalvalueof$100perloannote.Thebefore-taxcostofdebtofis9%andtheafter-taxcostofdebtof isWhatisthecurrentmarketvalueofeachloanCostofdebt-2019/06TheofCorfeCohaveanominalvalueof$100perloannoteandamarketpriceof$103·50perloannote.Annualinteresthasjustbeenpaidandtheloannotesareredeemableinfiveyears’timeata10%premiumtonominalvalue.CorfeCopayscorporation$5%PV10%PV0 5 IRR=5+((10–5)x(10·45/(10·45+10·93)))=Convertibleloan-Groadyhas7%bondswhichareredeemableattheirparvalue$100in3yearstime.Alternativelyeachbondcanbeconvertedinto25sharesin3yearstime.Thesharepriceiscurrently$4.50andisexpectedtogrowat5%p.a.Groady’sbondhasaofCalculatethefloorvalue(ieitsvalueifthebondwasnotconvertedintoshares)CalculatethemarketvalueofthisconvertibleSolution123Cash77dfTotalSharepricein3yrstime=4.50×1.053=25shares×$5.21=$130.25soconversionwillbepreferredAssumeinyear3$7interestisreceivedaswell123Cash77dfTotalEx-2016/09Q11LaneCohasinissue3%convertibleloannoteswhichareredeemableinfiveyears’timeattheirnominalvalueof$100perloannote.Alternatively,eachloannotecanbeconvertedinfiveyears’timeinto25LaneCoordinaryshares.ThecurrentsharepriceofLaneCois$3·60pershareandfuturesharepricegrowthisexpectedtobe5%peryear.Thebefore-taxcostofdebtoftheseloannotesis10%andcorporationtaxis30%.WhatisthecurrentABCD

ofaLaneCoconvertibleA11AnswerConversionvalue=3·60x1·05^5x25=,loannotevalue=(3x3·791)+(114·870·621)=Irredeemableloannotes,BlackCohasinissue5%nominalvalueof$100perloannote.BlackCohasabefore-taxcostofdebtof10%andcorporationtaxis30%,WhatisthecurrentmarketvalueofoneloanB.$Ex2017/06-Cum-interest,BlackCohasinissue5%nominalvalueof$100perloannote,onwhichinterestisshortlytobepaid.BlackCohasabefore-taxcostofdebtof10%andcorporationtaxis30%,WhatisthecurrentmarketvalueofoneloanA.$CostofpreferencesharesThepreferenceshareholderwillreceiveafixede,baseduponthenominalvalueofthesharesheld(notthemarketvalue).Thesedividends,whilstfixedandhenceshowingdebtcharacteristics,arepaidoutofpost-taxprofitsandthereforeDONOTreceivetaxrelief.Thecostofpreferencesharecapitaliscalculatedas:Kpref=PreferenceDividend=dMarketValue(exdiv) Ex2019/06The6%preferencesharesofCorfeCohaveanominalvalueof$0·75pershareandanex-dividendmarketpriceof$0·64pershare.Kpref=(0·06x0·75)/0·64=CostofabankloanThecostofabankloanwillbegivenbytheexaminer–multiplythisby(1-t)togettheposttaxcost.Thebankloanhasavariableinterestrate.Costofbankloan(%) Usecostofloannotesas WeightedaveragecostofcapitalWACC Ve=totalVd=

(ex-div)ofsharesi.e.market(ex-interest)ofKe=costofequityinagearedKd=costofdebtAthirdsourceoffinancemayhavetobeaddedintotheEx-2015/06Q19Onamarketvaluebasis,GFVCoisfinanced70%byequityand30%bydebt.The hasanafter-taxcostofdebtof6%andanequitybetaof1·2.Therisk- rateofreturnis4%andtheequityriskpremiumis5%.Whatistheafter-taxweightedaveragecostofcapitalofGFVEx-2014/12Q5TinepCois nningtoraisefundsforanexpansionofexistingbusinessactivitiesandinpreparationforthisthe decidedtocalculateitsweightedaveragecostofcapital.TinepCohasthefollowingcapitalstructure:Ordinaryshares

Non-currentLoan 2014/12Q5TheordinarysharesofTinepCohaveanominalvalueof50centspershareandarecurrentlytradingonthestockmarketonanexdividendbasisat$5.85pershare.TinepCohasanequitybetaof1.15.Theloannoteshaveanominalvalueof$100andarecurrentlytradingonthestockmarketonanexinterestbasisat$103.50perloannote.Theinterestontheloannotesis6%peryearbeforetaxandtheywillberedeemedinsixyears’timeata6%premiumtotheirnominalvalue.Therisk- rateofreturnis4%peryearandtheequityriskpremiumis6%peryear.TinepCopayscorporationtaxatanannualrateof25%peryear.(a)Calculatethe

weightedaveragecostofcapitalandweightedaveragecostofcapitalofTinepCo,andcommentbrieflyonanydifferencebetweenthetwoAnswerCostofUsingthecapitalassetpricingmodel,Ke=4+(1.15×6)=CostofdebtofloanAfter-taxannualinterestpayment=6×0·75=$4·50perloan$5%4%06Kd=4+[(1×3.83)/(3·83+1.58)]=4+0.7=4.7%perMarketvaluesofequityandNumberofordinaryshares=200m/0.5=400millionsharesMarketvalueofordinaryshares=400m×5.85=$2,340millionMarketvalueofloannotes=200m×103.5/100=$207millionTotalmarketvalue=2,340+207=$2,547millionMarketvalue=((10.9×2,340)+(4.7×207))/2,547=26,479/2,547=BookvalueK0=((10.9×850)+(4.7×200))/1,050=10,205/1,050=.Marketvaluesoffinancialsecuritiesreflectcurrentmarketconditionsandcurrentrequiredratesofreturn.Marketvaluesshouldtherefore incalculatingtheweightedaveragecostofcapital(WACC)whentheyare.Ifbookvaluesareused,theWACCislikelytobeunderstated,sincethenominalvaluesofordinarysharesaremuchlessthantheirmarketvalues.Thecontributionofthecostofequityisreducedifbookvaluesareused,leadingtoalowerWACC,asevidencedbythebookvalueWACC(9·7%)andthemarketvalueWACC(10·4%)ofTinepCo.Question31ThefollowinginformationhasbeentakenfromthestatementoffinancialpositionofCorfeCo,alisted Non-currentCurrentCashandcash4OthercurrentTotalEquityandOrdinaryQuestion3Non-current6%preference68%loan8Bank5Current7TotalequityandQuestion3TheordinarysharesofCorfeCohaveanominalvalueof$1pershareandacurrentex-dividendmarketpriceof$6·10pershare.Adividendof$0·90persharehasjustbeenpaid.The6%preferencesharesofCorfeCohaveandanex-dividendmarketpriceof$0·64perThe8%loannotesofCorfeCohaveanominalvalueof$100perloannoteandamarketpriceof$103·50perloannote.Annualinteresthasjustbeenpaidandtheloannotesareredeemableinfiveyears’timeata10%premiumtonominalvalue.ThebankloanhasavariableinterestTherisk- rateofreturnis3·5%peryearandtheequityriskpremiumis6·8%peryear.CorfeCohasanequitybetaof1·25.CorfeCopayscorporationtaxatarateofQuestion3InvestmentinCorfeCo’sboardislookingtofinanceinvestmentsinfacilitiesoverthenextthreeyears,forecasttocostupto$25m.Theboarddoesnotwishtoobtainfurtherlong-termdebtfinanceandisalsounwillingtomakeanequityissue.Thismeansthatinvestmentshavetobefinancedfromcashwhichcanbemadeavailableinternally.Boardmembershavemadeanumberofsuggestionsabouthowthiscanbedone:DirectorAhassuggestedthatthe doesnothaveaproblemwithfundingnewinvestments,asithascashavailableinthereservesof$29m.Ifextracashisrequiredsoon,CorfeCocouldreduceitsinvestmentinworkingcapital.Question3DirectorBhassuggestedsellingthebuildingwhichcontains’sheadquartersinthecapitalcityfor$20m.Thiswillraisealargeone-offsumandalsosaveonongoingpropertymanagementcosts.Headofficesupportfunctionswouldbemovedtoanumberofdifferentlocationsrentedoutsidethecapitalcity.DirectorChascommentedthatalthoughahighdividendhasjustbeenpaid,dividendscouldbereducedoverthenextthreeyears,allowingsparecashforinvestment.Question3Calculatetheafter-taxweightedaveragecostofcapitalofCorfeCoonamarketvaluebasis.(11marks)Discusstheviewsexpressedbythethreedirectorsonhowtheinvestmentshouldbefinanced.(9marks)AnswerKe=3·5%+(1·25x6·8%)=Kpref=(0·06x0·75)/0·64=LoanAftertaxinterest 8%x(1–0·2)=NominalvalueofloannotesMarketvalueofloannotesTimetoredemption(years)Redemptionpremium(%)

5Answer$5%PV10%PV0 5 IRR=5+((10–5)x(10·45/(10·45+10·93)))=ThisfigurecanalsobeusedforthecostofdebtofthebankAnswerMarketvaluesandWACCMVEquityPreference6Loan8Bank5WACC=100%x1,232·79/109·90=AnswerDirectorDirectorAisincorrectinsayingthat$29mofcashreservesareavailable.Reservesare$29m,butthisfigurerepresentsbackingforallCorfeCo’sassetsandnotjustcash.CorfeCohas$4mofcash.Someofthiscouldbeusedforinvestment,althoughthe willneedaminimumbalanceofcashtomaintainliquidityforitsday-to-dayoperations.CorfeCo’scurrentratiois(20/7)=2·86.Thismaybeahighfigure(dependingontheindustryCorfeCoisin),soCorfeComayhavescopetogeneratesomeextracashbyreducingworkingcapital.Inventorylevelscouldbereducedbyjust-in-timepolicies,tradereceivablesreducedbytightercreditcontrolandpaymentsdelayedto rs.Allofthesehavepossibledrawbacks.Just-in-timepoliciesmayresultinrunningoutofinventory,andtighterpoliciesfortradereceivablesandpayablesmayworsenrelationswithcustomersand Againalso,CorfeCowouldhavetomaintainminimumlevelsofeachelementofworkingcapital,soitseemsunlikelythatitcouldraisethe um$25msolelyby ngwhatDirectorADirectorSellingtheheadquarterswouldraisemostofthesumrequiredforinvestment,assumingthatDirectorB’sassessmentofsalespriceisaccurate.However,CorfeCowouldlosethebenefitofthevalueofthesiteincreasinginfuture,whichmayhappeniftheheadquartersisinaprimelocationinthecapitalcity.Beingabletoselltheheadquarterswouldbesubjecttotheagreementoflendersifthepropertyhadbeenusedassecurityforaloan.Evenifithasnotbeenusedassecurity,thesalecouldreducetheborrowingcapacityofthe reducingtheavailabilityofassetstoofferassecurity.Anongoingcommitmenttopropertymanagementcostsofanownedsitewouldbere cedbyacommitmenttopayrent,whichmightalsoincludesomeresponsibilityforpropertycostsforthelocationsrented.ItispossiblethatgooddealsforrentingareavailableoutsidethecapitalHowever,inthelongerterm,therentmayemoreexpensiveiftherearefrequentrentTheremayalsobevisibleandinvisiblecostsattachedtomovingandsplittingupthefunctions.Therewillbeone-offcostsofmovinganddisruptiontoworkaroundthetimeofthemove.Staffre cementcostsmayincreaseifstaffaremovedtoalocationwhichisnotconvenientforthemandthenleave.Seniormanagersmayfinditmoredifficulttomanagefunctionswhichareindifferentlocationsratherthanthesame ce.Theremaybealossofsynergiesthroughstaffindifferentfunctionsnotbeingabletocommunicateeasilyface-to-faceanyDirectorThedividendjustpaidof$13·5mseemsalargeamountcomparedwithtotalreserves.Ifasimilarleveloffundsisavailablefordistributionoverthenexttwoyears,notpayingadividendwouldfundtheforecastexpenditure.However,shareholdersmaywellexpectaconsistentorsteadilygrowingdividend.Acutindividendmayrepresentasignificantlossofeforthem.Ifthisisso,shareholdersmaybeunhappyaboutseeingdividendscutornotpaid,particularlyiftheyhavedoubtsaboutthedirectors’future ns.Theymayseethisasthatthe haspoorprospects,particularlyiftheyareunsureaboutwhythedirectorsarenotseekingfinancefromexternalsources.Thedirectors’dividend mayalsobequestionedifthedividendjustpaidwasaone-off,highpayment.Suchapaymentisnormallymadeifa hassurpluscashanddoesnothave nstouseit.However,thedirectorsare investments,andshareholdersmaywonderwhyahighdividendwaspaidwhenthedirectorsneedmoneyforinvestments.2017.12Question3ThefollowingstatementoffinancialpositioninformationrelatestoTufaCo,a onalargestockmarketwhichpayscorporationtaxatarateof30%.EquityandShareRetainedNon-currentLong-termCurrentTotalequityandQuestion3ThesharecapitalofTufaCoconsistsof$12mofordinaryshares$5mofirredeemablepreferenceTheordinarysharesofTufaCohaveanominalvalueof$0·50pershare,an arketpriceof$7·07pershareandamarketpriceof$7·52perDividendspaidinrecentyearsbeenas DividendDividend Question3The5%preferencesharesofTufaCohaveanominalvalueof$0·50pershareandanexdividendmarketpriceof$0·31pershare.Thelong-termborrowingsofTufaCoconsistof$10mofloannotesanda$3mbankloan.Thebankloanhasavariableinterestrate.The7%loannoteshaveanominalvalueof$100perloannoteandamarketpriceof$102·34perloannote.Annualinteresthasjustbeenpaidandtheloannotesareredeemableinfouryears’timeata5%premiumtonominalvalue. Calculatetheafter-taxweightedaveragecostofcapitalofTufaCoonamarketvaluebasis.(11marks)Answer-CostofCumCumdivshareprice($perExdivshareprice($per DividendDividendfor20X7($perDividendfor20X3($per DividendDividendgrowthrate5·02[(0·45/0·37)0·25–Costofequity 11·7[((0·45x1·05)/7·07)+CostofpreferenceNominalNominalvalue($perMarketprice($per DividendDividendrate5Costofpreferenceshares 8·06[(0·5xInterestrateofloannotes(%) Nominalvalueofloannotes($) Marketpriceofloannotes($) Timetoredemption Redemptionpremium Taxrate $04IRR (5+(1·45/(1·45+2·20)))=Costofbankloan 5·40Usecostofloannotesas Answer-MarketvaluesandWACCBV

LoanLoan 4Bank TheoriesofcapitalstructureTheoriesofcapitalstructureThevalueofa canbeexpressedasthepresentvalueofitsfuturecashflows,discountedatitsweightedaveragecostofcapital(WACC).Thevalueofa canthereforetheoreticallybe isedbyminimisingitsWACC.IftheWACCdependsonthecapitalstructureofa ,i.e.onthebalancebetweendebtandequity,thentheminimumWACCwillarisewhenthecapitalstructureisoptimal.Alltheoriesofcapitalstructureaimtofocusontheimpactofsothey thatanythingelsethatcouldaffecta ’scostofcapitalisconstant(egbusinessrisk)ordoesnotexist(egissuecostsonnewcapital).TraditionaltheoryThetraditionalviewofcapitalstructuresuggeststhattheWACCdecreasesasdebtisintroducedatlowlevelsofgearing,beforereachinga thenincreasingasthecostofequityrespondstoincreasingfinancialrisk.Modigliani&Miller(notax)MillerandModiglianioriginallyarguedthattheWACCisindependentofa ’scapitalstructure,dependingonlyonitsbusinessriskratherthanonitsfinancialrisk.Modigliani&Miller(withtax)Sinceinterestisatax-allowabledeductionincalculatingtaxableprofit,debtisatax-efficientsourceoffinanceandre cingequitywithdebtwilldecreasetheWACCofa financialdistressCostsofhigherdebtpayments,andofmanagingtheliquidationprocess.financialdistressLossofsales/highercostsfromrs.Saleofstockatbelowmarketvalue.AgencyAthighlevelsofgearing,restrictivecovenantspreventfirmsinvesting.DirectorAbelievesthereisanoptimalbalanceofdebt:equitywhereasdirectorBdoesnotbelievethatthegearingdecisionaffectsthevalueofthebusiness.WhichtheoriesarethedirectorssubscribingDirectorDirectorpMM(withMM(nopTraditionalMM(nopTraditionalMM(withpMM(noTraditionalAlfCo'sgearingis1:1debt:equity.Theindustryaverageis1:5.AlfCoislookingtoraisefinanceforinvestmentinanewprojectanditiswonderingwhethertoraisedebtorequity.Applyingthetraditionalview,whichofthefollowingispItshouldtakeondebtfinance,astodosowillsavepItshouldtakeonequityfinance,astheirgearingisprobablybeyondpItdoesn'tmatter,asitwon'taffectthereturnstheprojectspMoreinfo