January

FUNDAMENTAL OF FINANCIAL MANAGEMENT

1, 2015
TUTORIAL: COST OF CAPITAL
1. Chapter 13: 2, 4, 6, 7, 8, 10, 19, p. 390.

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.

3. Mackenzie Company’s current share price is $20 and it is expected to pay a $1

dividend per share next year. After that, the firm’s dividends are expected to grow
at a rate of 4% per year. Mackenzie has some debt outstanding with a yield to
maturity of 7%.
a. What is an estimate of Mackenzie’s cost of equity?

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?

c. Mackenzie has 5 million common shares outstanding and 1 million preferred

shares outstanding, and its equity has a total book value of $50 million. Its
debts have a market value of $20 million. If Mackenzie’s common and
preferred shares are priced as in parts (a) and (b), what is the market value of
Mackenzie’s assets?

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
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FUNDAMENTAL OF FINANCIAL MANAGEMENT
1, 2015
 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.

5. Big Company Ltd is investigating whether or not to proceed with project X. it is

considered that project X is of the same nature of business as all existing
operations and as a result the firm present WACC can be used to calculate its
viability.
The cash flows associated with the project are as follows:

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

Corporate Tax Rate 30%

Number of shares on issue 10 million
Current Share Price $7.25
 January
FUNDAMENTAL OF FINANCIAL MANAGEMENT
1, 2015
Equity Beta 1.47
Expected Return on the Market 12%
Risk Free Rate applicable 7%

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.