CFEA2123/2124 MANAGERIAL FINANCE/BASIC MANAGERIAL FINANCE (FEB 2013)

UNIVERSITI MALAYA FACULTY OF BUSINESS AND ACCOUNTANCY

ACADEMIC YEAR 2013 BACHELOR OF ACCOUNTING

TUTORIAL 11 (QUESTIONS) COST OF CAPITAL 11-1. How does the cost of a source of capital relate to the valuation concepts presented previously in capital budgeting? (Learning Outcome: 3)

11-2.

What effect would inflation have on a company's cost of capital? (Hint: Think about how inflation influences interest rates, share prices, corporate profits, and growth.) (Learning Outcome: 3)

11-3.

Why do we use the overall cost of capital for investment decisions even when only one source of capital will be used (e.g., debt)? (Learning Outcome: 3)

11-4.

In computing the cost of capital, do we use the historical costs of existing debt and equity or the current costs as determined in the market? Why? (Learning Outcome: 3) Why is the cost of debt less than the cost of preference share if both securities are priced to yield 10 percent in the market? (Learning Outcome: 3)

11-5.

11-6.

What are the two sources of equity (ownership) capital for the firm? Explain why retained earnings have an opportunity cost associated? (Learning Outcome: 3)

11-7.

Why is the cost of retained earnings the equivalent of the firm's own required rate of return on ordinary share (Ke)? (Learning Outcome: 3)

11-8.

Why is the cost of issuing new ordinary share (external equity) higher than the cost of retained earnings (internal equity)?

CFEA2123/2124 MANAGERIAL FINANCE/BASIC MANAGERIAL FINANCE (FEB 2013) (Learning Outcome: 3)

11-9.

How are the weights determined to arrive at the optimal weighted average cost of capital (WACC)? (Learning Outcome: 3)

11-10.

The NZ Charitable Foundation (NCF), which is tax-exempt, issued debt last year at 8 percent to help finance a new playground facility in Sungai Long. This year the cost of debt is 15 percent higher; that is, firms that paid 8 percent for debt last year would be paying 9.2 percent this year. a. If the NCF borrowed money this year, what would the after-tax cost of debt be, based on their cost last year and the 15 percent increase? b. If the NCF was found to be taxable by the Inland Revenue (at a rate of 35 percent) because it was involved in political activities, what would the aftertax cost of debt be? (Learning Outcome: 3)

11-11.

NZ has a RM1,000 par value bond outstanding with 25 years to maturity. The bond carries an annual interest payment of RM88 and is currently selling for RM925. NZ is in a 25 percent tax bracket. The firm wishes to know what the after-tax cost of a new bond issue is likely to be. The yield to maturity on the new issue will be the same as the yield to maturity on the old issue because the risk and maturity date will be similar. a. Compute the approximate yield to maturity on the old issue and use this as the yield for the new issue. b. Make the appropriate tax adjustment to determine the after-tax cost of debt. (Learning Outcome: 3)

11-12.

The treasurer of NZ is asked to compute the cost of fixed income securities for her company. Even before making the calculations, she assumes the after-tax cost of debt is at least 2 percent less than that for preference share. Based on the following facts, is she correct? Debt can be issued at a yield of 11 percent, and the corporate tax rate is 30 percent. Preference share will be priced at RM50, and pay a dividend of RM4.80. The floatation cost on the preference share is RM2.10. (Learning Outcome: 3)

11-13.

Compute cost of internal and external equity, respectively, under the following circumstances: a. D1 = RM4.20, P0 = RM55, g = 5%, F (flotation cost) = RM3.80. b. D1 = RM0.40, P0 = RM15, g = 8%, F = RM1. c. E1 (earnings at the end of period one) = RM8, payout ratio equals 25 2

CFEA2123/2124 MANAGERIAL FINANCE/BASIC MANAGERIAL FINANCE (FEB 2013) percent, P0 = RM32, g = 5%, F = RM2. d. D0 (dividend at the beginning of the first period) = RM3, growth rate for dividends and earnings (g) = 9%, P0 = RM60, F = RM3.50. (Learning Outcome: 3) (a) NZs capital structure is as follows:

11-14.

Debt ...................................... Preference share .................. Equity ...................................

35% 15 50

The after-tax cost of debt is 6.5 percent; the cost of preference share is 10 percent; and the cost of equity (in the form of retained earnings) is 13.5 percent. Calculate NZs weighted average cost of capital (WACC). (b) As an alternative to the capital structure shown in problem (a) above for NZ, an outside consultant has suggested the following modifications. Debt ............................................... Preference ..................................... Equity ............................................ 60% 5 35

Under this new, more debt-oriented arrangement, the after-tax cost of debt is 8.8 percent; the cost of preference share is 11 percent; and the cost of equity (in the form of retained earnings) is 15.6 percent. Recalculate NZs WACC. Which plan is optimal in terms of cost of capital? (Learning Outcome: 3)

11-15.

Given the following information, calculate the WACC for NZ.

Percent of capital structure: Debt ............................................... Preference share ........................... Equity ............................................ Additional information: Bond coupon rate .......................... 13% Bond yield to maturity .................... 11% Dividend, expected ordinary........... RM3 Dividend, preference ...................... RM10 Price, ordinary share ...................... RM50 Price, preference share.................. RM98 Flotation cost, preference share ..... RM5.50 3 30% 15 55

CFEA2123/2124 MANAGERIAL FINANCE/BASIC MANAGERIAL FINANCE (FEB 2013) Growth rate .................................... Corporate tax rate .......................... (Learning Outcome: 3) 8% 30%

11-16.

NZ is trying to calculate its cost of capital for use in a capital budgeting decision. Mr. NY, the vice president of finance, has given you the following information and has asked you to compute the WACC. The company currently has outstanding a bond with a 12 percent coupon rate and a convertible bond with an 8.1 percent coupon rate. The firm has been informed by its investment banker that bonds of equal risk and credit rating are now selling to yield 14 percent. The ordinary share has a price of RM30 and an expected dividend of RM1.30 per share. The firm's historical growth rate of earnings and dividends per share has been 15.5 percent, but security analysts expect this growth to slow to 12 percent in future. The preference share is selling at RM60 per share and carries a dividend of RM6.80 per share. The corporate tax rate is 30 percent. The flotation costs are 3 percent of the selling price for preference share. The optimum capital structure for the firm seems to be 45 percent debt, 5 percent preference share, and 55 percent equity in the form of retained earnings. Compute the cost of capital for the individual components in the capital structure, and then calculate the WACC. (Learning Outcome: 3)

11-17.

NZ faces increasing needs for capital. Fortunately, it has an AAa credit rating. The corporate tax rate is 36 percent. First NZs treasurer is trying to determine the corporation's current WACC in order to assess the profitability of capital budgeting projects. Historically, the corporation's earning and dividends per share have increased at about 6 percent annual rate. NZs ordinary share is selling at RM60 per share, and the company will pay a RM4.80 per share dividend. The company's RM100 preference share has been yielding 9 percent in the current market. Flotation costs for the company have been estimated by its investment banker to be RM1.50 for preference share. The company's optimum capital structure is 40 percent debt, 10 percent preference share, and 50 percent equity in the form of retained earnings. Refer to the table below on bond issues for comparative yields on bonds of equal risk to NZ. Compute the answer to questions a, b, c, and d from the information given. Data on Bond Issues Issue Altra Berhad (AB) 8 s 2010 Bltra Berhad (BB) 7 1/2s 2009 Cltra Berhad (CB) 9.62s 2011 4 Moody's Rating AAA AAa Aaa Price RM 975.25 850.75 960.50 Yield to Maturity 8.60% 9.11 9.67

CFEA2123/2124 MANAGERIAL FINANCE/BASIC MANAGERIAL FINANCE (FEB 2013) Compute the answers to the following questions from the information given. a. Cost of debt, Kd. (Use the above tablerelate to the bond credit rating for yield). b. Cost of preferred stock, Kp. c. Cost of equity in the form of retained earnings, Ke. d. Weighted average cost of capital, WACC. (Learning Outcome: 3)

11-18.

NZ has the following capital structure: Cost (after-tax) 7.1% 8.6 14.1 Weighted Cost 2.66% .86 9.17 12.69%

Debt (Kd) ............................... Preference share (Kp) ........... Equity (Ke) (retained earnings) .............. Weighted average cost of capital (WACC) ...............

Weights 25% 10 65

a. If the firm has RM19.5 million in retained earnings, at what size capital structure will the firm run out of retained earnings. b. The 7.1 percent cost of debt referred to above applies only to the first RM14 million of debt. After that the cost of debt will go up. At what size capital structure will there be a change in the cost of debt? (Learning Outcome: 3)

11-19.

NZ finds it is necessary to determine its marginal cost of capital. NZ's current capital structure calls for 45 percent debt, 15 percent preference share, and 40 percent equity. Initially, equity will be in the form of retained earnings and then new ordinary shares. The costs of the various sources of financing are as follows: debt, 6.2 percent; preference share, 9.4 percent; retained earnings, 12.0 percent; and new ordinary share, 13.4 percent. a. What is the initial WACC? (Include debt, preference share, and equity in the form of retained earnings.) b. If the firm has RM20 million in retained earnings, at what size capital structure will the firm run out of retained earnings? c. What will the marginal cost of capital be immediately after that point? (Equity will remain at 40 percent of the capital structure, but will all be in the form of new ordinary share.) d. The 6.2 percent cost of debt referred to above applies only to the first RM36 million of debt. After that the cost of debt will be 7.8 percent. At what size capital structure will there be a change in the cost of debt? e. What will the marginal cost of capital be immediately after that point? (Consider the facts in both parts c and d.) (Learning Outcome: 3)

CFEA2123/2124 MANAGERIAL FINANCE/BASIC MANAGERIAL FINANCE (FEB 2013) 11-20. NZ finds it is necessary to determine its marginal cost of capital. NZ's current capital structure calls for 40 percent debt, 5 percent preference share, and 55 percent equity. Initially, equity will be in the form of retained earnings and then new ordinary share. The costs of the various sources of financing are as follows: debt, 7.4 percent; preference share, 10.0 percent; retained earnings, 13.0 percent; and new ordinary share, 14.4 percent. a. What is the initial WACC? (Include debt, preference share, and equity in the form of retained earnings.) b. If the firm has RM27.5 million in retained earnings, at what size capital structure will the firm run out of retained earnings? c. What will the marginal cost of capital be immediately after that point? (Equity will remain at 55 percent of the capital structure, but will all be in the form of new ordinary share.) d. The 7.4 percent cost of debt referred to above applies only to the first RM32 million of debt. After that the cost of debt will be 8.6 percent. At what size capital structure will there be a change in the cost of debt? e. What will the marginal cost of capital be immediately after that point? (Consider the facts in both parts c and d.) (Learning Outcome: 3)