Question Tag: Cost of Equity

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FM – Nov 2021 – L3 – Q3 – Financing Decisions and Capital Markets

Analyze financing alternatives for ZY Plc's new investment and assess rights issue and bond issue implications.

Question

ZY Plc is an all-equity financed, publicly listed company in the food processing industry. The ZY family holds 40% of its ordinary shares, with the remainder owned by large financial institutions. ZY Plc currently has 10 million ₦1 ordinary shares in issue.

Recently, the company secured a long-term contract to supply food products to a large restaurant chain, necessitating an investment in new machinery costing ₦24 million. This machinery will be operational starting January 1, 2022, with payment due the same day, and sales commencing shortly afterward.

The company’s policy is to distribute all profits as dividends. If ZY Plc continues as an all-equity financed company, it will pay an annual dividend of ₦9 million indefinitely, starting December 31, 2022.

To finance the ₦24 million investment, ZY Plc is considering two options:

A 2-for-5 rights issue, where the annual dividend would remain at ₦9 million. The cum-rights price per share is expected to be ₦6.60.
Issuing 7.5% irredeemable bonds at par with interest payable annually in arrears. For this option, interest would be paid out of the ₦9 million otherwise allocated to dividends.

Under either financing method, the cost of equity is anticipated to remain at its current rate of 10% annually, with no tax implications.

Required:

a. Calculate the issue and ex-rights share prices of ZY Plc., assuming a 2-for-5 rights issue is used to finance the new project as of January 1, 2022. Ignore taxation. (4 Marks)

b. Calculate the value per ordinary share in ZY Plc on January 1, 2022, if 7.5% irredeemable bonds are issued to finance the new project. Assume that the cost of equity remains at 10% each year. Ignore taxation. (4 Marks)

c. Write a report to the directors of ZY Plc that includes: i. A comparison and contrast of the rights issue and bond issue methods for raising finance, referencing calculations from parts (a) and (b) and any assumptions. (6 Marks)
ii. A discussion on the appropriateness of the following alternative methods of issuing equity finance in the specific context of ZY Plc: – A placing – An offer for sale – A public offer for subscription (6 Marks)

Answer

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Tags: Bond Issue, Cost of Equity, Dividend Policy, Equity Financing, Financial strategy, Financing Alternatives, Investment Financing, Public Offering, Rights Issue, Share Valuation
Level: Level 3

Topic: Financing Decisions and Capital Markets

FM – Nov 2020 – L3 – Q6 – Dividend Policy

Evaluates the dividend payout and investment appraisal for Binko Industrial Services based on Modigliani and Miller's dividend policy, considering four potential projects.

Question

Binko Industrial Services plc is an all-equity financed and Stock Exchange-listed company. Recently, there have been changes at the board level, prompting a shift from conservative profit distribution to seeking new investment opportunities. In the financial year just ended, the company reported a profit of ₦50 million, similar to previous years. The company’s cost of equity is 15% per annum, and four investment projects have been identified, each with the same risk class as existing projects.

Required:

a. Calculate the dividend Binko Industrial Services plc should pay to shareholders in the financial year just ended, based on Modigliani and Miller’s 1961 proposition, ignoring taxation. (5 Marks)

b. Prepare notes for the board meeting, explaining Modigliani and Miller’s dividend policy proposition and reasons why the company may decide against the calculated dividend in (a). Your comments should address Binko’s circumstances. Work to the nearest ₦1,000. (15 Marks)

Answer

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Tags: Cash Flow Analysis, Cost of Equity, Dividend Policy, investment projects, Modigliani and Miller
Level: Level 3

Topic: Dividend Policy

FM – Nov 2017 – L3 – Q2 – Mergers and Acquisitions

Calculate Raymond Plc.'s valuation, analyze Harold Limited's acquisition value, and assess the offer price from shareholders' perspectives.

Question

Raymond Plc. is a successful IT services company incorporated 10 years ago. It was listed on the Stock Exchange 3 years ago. The company has a broad customer base mainly consisting of small and medium-sized companies. Raymond Plc. has achieved rapid growth in recent years by obtaining regular business from satisfied customers and also by acquiring other IT services companies.

The Directors of Raymond Plc. have identified Harold Limited, an unlisted company, as a possible acquisition target. Harold Limited has a number of large multinational clients, and, in general, its clients tend to be larger than those of Raymond Plc. If successful, the acquisition would go ahead on January 1, 2018.

Forecast financial data for Raymond Plc. and Harold Limited as of December 31, 2017, are summarized below:

Financial Item	Raymond Plc.	Harold Limited
Share capital (Ordinary ₦1 shares)	₦150m	₦40m
Market share price	₦4.90	N/A

N/A: Not applicable (not listed).

Additional information:

If Harold Limited were to remain an independent company, its Directors estimate that reported Profit After Tax would be ₦15 million for 2018 and then grow by 2% yearly in perpetuity;
If the acquisition were to go ahead, Raymond Plc.’s Directors estimate that Harold Limited’s profit after tax would be 5% higher for 2018 than if the company remains an independent company, and that profit after tax would then grow by 3% yearly in perpetuity;
The average ungeared Cost of Equity for the industry is 8%;
Both Raymond Plc. and Harold Limited are wholly equity financed; and
Profit after tax can be assumed to be a good approximation of free cash flow attributable to investors.

The Directors of Raymond Plc. are considering offering to purchase Harold Limited at a price of ₦7.00 per share. It is estimated that transaction costs of ₦8 million would be payable on the acquisition and that ₦2 million would be required in the first year to cover the costs of integrating the two companies.

Required:

(a) Calculate:
- i. The value of Raymond Plc. as at December 31, 2017.
- ii. The value of Harold Limited as at December 31, 2017 before taking the possible acquisition of the company by Raymond Plc. into account.
- iii. The overall increase in value created by the acquisition of Harold Limited by Raymond Plc. (8 Marks)
(b)
- i. Explain how value might be created by the proposed acquisition. (2 Marks)
- ii. Comment on the difficulties which Raymond Plc. is likely to face in realizing the potential added-value, after the acquisition. (2 Marks)
(c) Evaluate the proposed offer price of ₦7.00 per share for Harold Limited from the point of view of:
- i. Harold Limited’s shareholders.
- ii. Raymond Plc.’s shareholders. (8 Marks)

(Total 20 Marks)

Answer

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Tags: Acquisition, Cost of Equity, Free Cash Flow, Integration Costs, IT Services, Shareholder Analysis, Stock Exchange, Synergies, Valuation
Level: Level 3

Topic: Mergers and acquisitions
Series: NOV 2017

AFM – Nov 2016 – L3 – Q3a – Sources of finance and cost of capital

Calculate the cost of equity for Sunland Co using the Capital Asset Pricing Model (CAPM) with a focus on deriving beta from industry data.

Question

a) The directors of Sunland Company, a company which has 75% of its operations in the retail
sector and 25% in manufacturing, are trying to derive the firm’s cost of equity. However, since
the company is not listed, it has been difficult to determine an appropriate beta factor. The
following information was researched:

Retail industry – quoted retailers have an average equity beta of 1.20, and an average
gearing ratio of 20:80 (debt: equity).
Manufacturing industry – quoted manufacturers have an average equity beta of 1.45 and
an average gearing ratio of 45:55 (debt: equity).
The risk free rate is 3% and the equity risk premium is 6%.
Tax on corporate profits is 30%.
Sunland Co has gearing ratio of 50% debt and 50% equity by market values. Assume that
the risk on corporate debt is negligible.

Required:
Calculate the cost of equity of Sunland Company using the Capital Asset Pricing Model.

Answer

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Tags: Beta calculation, CAPM, Corporate finance, Cost of Equity, Gearing
Level: Level 3

Topic: Sources of finance and cost of capital
Series: NOV 2016

FM – May 2021 – L2 – Q3b – Cost of Capital

Calculate Gbewaa Ghana Ltd’s Weighted Average Cost of Capital

Question

b) Gbewaa Ghana Ltd has issued 10 million shares with a market value of GH¢5 per share. The equity beta of the company is 1.2. The current yield of short-term government debt is 14% per annum, and the equity risk premium is approximately 5% per annum. The debt finance of Gbewaa Ghana Ltd consists of bonds with a book value of GH¢10,000,000. These bonds pay interest at 18% per annum, and the par value and market value of each bond is GH¢100. The company’s tax rate is 25%.

Required:

Calculate Gbewaa Ghana Ltd’s Weighted Average Cost of Capital. (9 marks)

Answer

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Tags: Cost of Debt, Cost of Equity, WACC, Weighted Average Cost of Capital
Level: Level 2

Topic: Cost of capital
Series: MAY 2021

FM – Nov 2020 – L2 – Q1b – Cost of capital | Portfolio theory and the capital asset pricing model (CAPM)

Calculate the appropriate discount rate for a new subsidiary in the U.S. using CAPM and Modigliani-Miller Proposition II.

Question

The directors of Fameko Ltd (Fameko), a courier delivery services company based in Ghana, are considering a proposal for setting up a subsidiary in the United States of America to provide courier services in North America. The capital of this new subsidiary will be structured as 20% equity and 80% debt.

The directors are not sure of what would be an appropriate discount rate for appraising the North American business. You have been asked to recommend an appropriate discount rate for this project. You have gathered the following information for this exercise.

Competition in the U.S. Courier industry:
The U.S. courier services industry is highly competitive. If Fameko sets up in the U.S., its main competitor will be ExFed Corporation. ExFed’s capital structure is 70% equity and 30% debt.
Market risk:
The following statistics have been computed from historical excess returns on the equity stock of ExFed Corporation and that on the S&P 500 Index (a proxy for the market portfolio):

	S&P 500 Index	ExFed Equity Stock
Average return	0.0628	0.0321
Standard Deviation	0.1875	0.1521
Sample Variance	0.0352	0.0231
Kurtosis	-1.4335	-1.1121
Skewness	-0.2178	-0.1601

You analyzed the correlation between the excess returns on ExFed and excess returns on the S&P 500 Index and obtained a correlation coefficient of 0.91.

The annual risk-free rate and market return:
The annual rate of interest on the 10-year U.S. Treasury bond is 2.1%. The expected return on the S&P 500 Index is 7%.
Taxation:
ExFed pays corporate income tax at the rate of 30%. However, the effective corporate income tax rate on profits from Fameko’s North American operations will be 35%.

Required:

i) Compute the equity beta of ExFed. (3 marks)

ii) Derive an appropriate equity beta for Fameko’s U.S. subsidiary. (4 marks)

iii) Using the capital asset pricing model or the Modigliani and Miller Proposition II with tax, compute an appropriate cost of equity for Fameko’s U.S. subsidiary. (3 marks)

Answer

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Tags: Beta calculation, CAPM, Cost of Equity, Discount rate, Risk Management
Level: Level 2

Topic: Cost of capital, Portfolio theory and the capital asset pricing model (CAPM)
Series: NOV 2020

FM – Nov 2019 – L2 – Q1b – Cost of capital

Calculate the weighted average cost of capital using the dividend valuation model and capital asset pricing model.

Question

A colleague has been taken ill. Your managing director has asked you to take over from the colleague and to provide urgently-needed estimates of the discount rate to be used in appraising a large new capital investment. You have been given your colleague’s working notes, which you believe to be numerically accurate.

Working notes: Estimates for the next five years (annual averages) Stock market total return on equity 16% Own company dividend yield 7% Own company share price rise 14% Standard deviation of total stock market return on equity 10% Systematic risk of own company return on equity 14% Growth rate of own company earnings 12% Growth rate of own company dividends 11% Growth rate of own company sales 13% Treasury bill yield 12%

The company’s gearing level (by market values) is 1 : 2 debt to equity, and after-tax earnings available to ordinary shareholders in the most recent year were GH¢54,000,000, of which GH¢21,400,000 was distributed as ordinary dividends.

The company has 1 million issued ordinary shares which are currently trading on the Stock Exchange at GH¢3.21. Corporate debt may be assumed to be risk-free. The company pays tax at 30% and personal taxation may be ignored.

Required: Estimate the company’s weighted average cost of capital using:
i) The dividend valuation model.
ii) The capital asset pricing model.

State clearly any assumptions that you make. Under what circumstances these models would be expected to produce similar values for the weighted average cost of capital? (10 marks)

Answer

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Tags: Capital Asset Pricing Model, Cost of Debt, Cost of Equity, Dividend Valuation Model, Weighted Average Cost of Capital
Level: Level 2

Topic: Cost of capital
Series: NOV 2019

FM – Nov 2017 – L2 – Q2a – Cost of capital

Calculate Zaytuna Ltd's Weighted Average Cost of Capital (WACC).

Question

One of your clients has seen many references to the “Cost of Capital” in the Business and Financial Times and has asked you to give him some guidance on what would be an appropriate figure for his organization-Zaytuna Ltd. The following information is available for Zaytuna Ltd.

Existing capital structure:

Issued ordinary shares-12,000,000 GH¢12,000
Retained earnings GH¢4,000
6% Preference shares GH¢2,000
9% Debenture repayable 2018 GH¢6,000
Total GH¢24,000

Details:

9% Debenture: Issued in 2008 at par, Current price GH¢92, A similar issue if made now would require to be at GH¢90.
Preference Shares: Preference shares have a par value of GH¢1 and were originally issued at 92p per share, Current price 43p, A similar issue if made now would require to be 40p per share.
Ordinary Share: The market price of an ordinary share is GH¢7.00, GH¢6 million in dividends were paid this year which represented 75% of earnings, Earnings are expected to grow at an annual rate of 5%, If new ordinary shares were issued now, costs incurred would represent 25p per share and a reduction below market value of 50p per share would also be made.
Corporate tax rate is 25%

Required:
Calculate Zaytuna Ltd’s Weighted Average cost of capital. (15 marks)

Answer

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Tags: Cost of Debt, Cost of Equity, Weighted Average Cost of Capital
Level: Level 2

Topic: Cost of capital
Series: NOV 2017

FM – MAY 2018 – L2 – Q3 – Cost of capital | Introduction to Investment Appraisal

Involves the calculation of the cost of various sources of capital, the weighted average cost of capital (WACC), and the net present value (NPV) of a proposed project, as well as an explanation of transaction and economic exposures and methods of mitigating transaction exposure.

Question

a) Okechukwu Ltd is financed by three types of capital:

i) 1 million 50p ordinary shares each having a current market value of GH¢5.20 cum div. The current dividend, which is due to be paid shortly, is 20p per share. The dividend has grown steadily in the past at a compound annual rate of 15% and is generally expected to continue doing so indefinitely.
ii) 200,000 GH¢1 irredeemable 8% preference shares, each having a current market value of 50p ex div.
iii) GH¢2 million 10% debentures, redeemable in 20 years at a price of 110. The current market value is 80 ex int.

Okechukwu is considering a new project having the same risk characteristics as existing projects, which would require an immediate outlay of GH¢150,000 and would produce annual net cash inflow of GH¢30,000 indefinitely.

Required:

Evaluate the viability of the new project using appropriate computations.
(15 marks)

b) Foreign currency risk can be managed to reduce or eliminate the risk. Measures to reduce currency risk are known as hedging.

Required:

i) Explain Transaction and Economic Exposure.
(5 marks)

ii) Explain FIVE ways of mitigating transaction exposure.
(5 marks)

Answer

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Tags: Cost of Equity, Debentures, Economic Exposure, NPV, Preference shares, Transaction Exposure, WACC
Level: Level 2

Topic: Cost of capital, Introduction to Investment Appraisal
Series: MAY 2018

FM – MAY 2018 – L2 – Q2 – Cost of capital

This question involves calculating the cost of equity, WACC before and after a bond issue, the ex-rights price, and evaluating the impact of a rights issue on a shareholder's wealth.

Question

a) The Finance Director of Vista Hotel has heard that the market value of the company will increase if the weighted average cost of capital of the company is decreased. The company, which is listed on a stock exchange, has 100 million shares in issue and the current ex-div ordinary share price is GH¢2.50 per share. Vista Hotel also has in issue bonds with a book value of GH¢60 million and their current ex-interest market price is GH¢104 per GH¢100 bond. The current after-tax cost of debt of Vista Hotel is 7% and the tax rate is 30%. The recent dividends per share of the company are as follows:

The Finance Director proposes to decrease the weighted average cost of capital of Vista Hotel and hence increase its market value by issuing GH¢40 million of bonds at their par value of GH¢100 per bond. These bonds would pay annual interest of 8% before tax and would be redeemed at a 5% premium to par after 10 years.

Required:

i) Determine the cost of equity capital of the company.
(4 marks)

ii) Calculate the weighted average cost of capital of Vista Hotel in the following circumstances:

Before the new issue of bonds takes place;
(3 marks)
After the new issue of bonds takes place.
(3 marks)

b) The Moorgate Company has issued 100,000 GH¢1 par equity shares which are at present selling for GH¢3.00 per share. It has also issued 50,000 warrants, each entitling the holder to buy one equity share. The warrants are protected against dilution. The company has plans to issue rights to purchase one new equity share at a price of GH¢2 per share for every four shares.

Required:

i) Calculate the theoretical ex-rights price of Moorgate’s equity shares.
(4 marks)

ii) Calculate the theoretical value of a Moorgate right, before the shares sell ex-rights.
(3 marks)

c) The chairman of the company receives a phone call from an angry shareholder who owns 1,000 shares. The shareholder argues that he will suffer a loss in his personal wealth due to this rights issue because the new shares are being offered at a price lower than the current market value.

The chairman assures him that his wealth will not be reduced because of the rights issue, as long as the shareholder takes appropriate action.

Required:

Prepare a statement showing the effects of the right issue on this particular shareholder’s wealth, assuming:

i) He sells all the rights.
(3 marks)

ii) He exercises one half of the rights and sells the other.
(3 marks)

iii) He does nothing.
(2 marks)

Answer

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Tags: Cost of Equity, Rights Issue, Shareholder Wealth, Weighted Average Cost of Capital (WACC)
Level: Level 2

Topic: Cost of capital
Series: MAY 2018

FM – Nov 2021 – L3 – Q3 – Financing Decisions and Capital Markets

Analyze financing alternatives for ZY Plc's new investment and assess rights issue and bond issue implications.

Question

To finance the ₦24 million investment, ZY Plc is considering two options:

A 2-for-5 rights issue, where the annual dividend would remain at ₦9 million. The cum-rights price per share is expected to be ₦6.60.
Issuing 7.5% irredeemable bonds at par with interest payable annually in arrears. For this option, interest would be paid out of the ₦9 million otherwise allocated to dividends.

Under either financing method, the cost of equity is anticipated to remain at its current rate of 10% annually, with no tax implications.

Required:

a. Calculate the issue and ex-rights share prices of ZY Plc., assuming a 2-for-5 rights issue is used to finance the new project as of January 1, 2022. Ignore taxation. (4 Marks)

Answer

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Tags: Bond Issue, Cost of Equity, Dividend Policy, Equity Financing, Financial strategy, Financing Alternatives, Investment Financing, Public Offering, Rights Issue, Share Valuation
Level: Level 3

Topic: Financing Decisions and Capital Markets

FM – Nov 2020 – L3 – Q6 – Dividend Policy

Evaluates the dividend payout and investment appraisal for Binko Industrial Services based on Modigliani and Miller's dividend policy, considering four potential projects.

Question

Required:

a. Calculate the dividend Binko Industrial Services plc should pay to shareholders in the financial year just ended, based on Modigliani and Miller’s 1961 proposition, ignoring taxation. (5 Marks)

Answer

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Tags: Cash Flow Analysis, Cost of Equity, Dividend Policy, investment projects, Modigliani and Miller
Level: Level 3

Topic: Dividend Policy

FM – Nov 2017 – L3 – Q2 – Mergers and Acquisitions

Calculate Raymond Plc.'s valuation, analyze Harold Limited's acquisition value, and assess the offer price from shareholders' perspectives.

Question

Forecast financial data for Raymond Plc. and Harold Limited as of December 31, 2017, are summarized below:

Financial Item	Raymond Plc.	Harold Limited
Share capital (Ordinary ₦1 shares)	₦150m	₦40m
Market share price	₦4.90	N/A

N/A: Not applicable (not listed).

Additional information:

If Harold Limited were to remain an independent company, its Directors estimate that reported Profit After Tax would be ₦15 million for 2018 and then grow by 2% yearly in perpetuity;
If the acquisition were to go ahead, Raymond Plc.’s Directors estimate that Harold Limited’s profit after tax would be 5% higher for 2018 than if the company remains an independent company, and that profit after tax would then grow by 3% yearly in perpetuity;
The average ungeared Cost of Equity for the industry is 8%;
Both Raymond Plc. and Harold Limited are wholly equity financed; and
Profit after tax can be assumed to be a good approximation of free cash flow attributable to investors.

Required:

(a) Calculate:
- i. The value of Raymond Plc. as at December 31, 2017.
- ii. The value of Harold Limited as at December 31, 2017 before taking the possible acquisition of the company by Raymond Plc. into account.
- iii. The overall increase in value created by the acquisition of Harold Limited by Raymond Plc. (8 Marks)
(b)
- i. Explain how value might be created by the proposed acquisition. (2 Marks)
- ii. Comment on the difficulties which Raymond Plc. is likely to face in realizing the potential added-value, after the acquisition. (2 Marks)
(c) Evaluate the proposed offer price of ₦7.00 per share for Harold Limited from the point of view of:
- i. Harold Limited’s shareholders.
- ii. Raymond Plc.’s shareholders. (8 Marks)

(Total 20 Marks)

Answer

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Tags: Acquisition, Cost of Equity, Free Cash Flow, Integration Costs, IT Services, Shareholder Analysis, Stock Exchange, Synergies, Valuation
Level: Level 3

Topic: Mergers and acquisitions
Series: NOV 2017

AFM – Nov 2016 – L3 – Q3a – Sources of finance and cost of capital

Calculate the cost of equity for Sunland Co using the Capital Asset Pricing Model (CAPM) with a focus on deriving beta from industry data.

Question

Retail industry – quoted retailers have an average equity beta of 1.20, and an average
gearing ratio of 20:80 (debt: equity).
Manufacturing industry – quoted manufacturers have an average equity beta of 1.45 and
an average gearing ratio of 45:55 (debt: equity).
The risk free rate is 3% and the equity risk premium is 6%.
Tax on corporate profits is 30%.
Sunland Co has gearing ratio of 50% debt and 50% equity by market values. Assume that
the risk on corporate debt is negligible.

Required:
Calculate the cost of equity of Sunland Company using the Capital Asset Pricing Model.

Answer

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Tags: Beta calculation, CAPM, Corporate finance, Cost of Equity, Gearing
Level: Level 3

Topic: Sources of finance and cost of capital
Series: NOV 2016

FM – May 2021 – L2 – Q3b – Cost of Capital

Calculate Gbewaa Ghana Ltd’s Weighted Average Cost of Capital

Question

Required:

Calculate Gbewaa Ghana Ltd’s Weighted Average Cost of Capital. (9 marks)

Answer

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Tags: Cost of Debt, Cost of Equity, WACC, Weighted Average Cost of Capital
Level: Level 2

Topic: Cost of capital
Series: MAY 2021

FM – Nov 2020 – L2 – Q1b – Cost of capital | Portfolio theory and the capital asset pricing model (CAPM)

Calculate the appropriate discount rate for a new subsidiary in the U.S. using CAPM and Modigliani-Miller Proposition II.

Question

Competition in the U.S. Courier industry:
The U.S. courier services industry is highly competitive. If Fameko sets up in the U.S., its main competitor will be ExFed Corporation. ExFed’s capital structure is 70% equity and 30% debt.
Market risk:
The following statistics have been computed from historical excess returns on the equity stock of ExFed Corporation and that on the S&P 500 Index (a proxy for the market portfolio):

	S&P 500 Index	ExFed Equity Stock
Average return	0.0628	0.0321
Standard Deviation	0.1875	0.1521
Sample Variance	0.0352	0.0231
Kurtosis	-1.4335	-1.1121
Skewness	-0.2178	-0.1601

You analyzed the correlation between the excess returns on ExFed and excess returns on the S&P 500 Index and obtained a correlation coefficient of 0.91.

The annual risk-free rate and market return:
The annual rate of interest on the 10-year U.S. Treasury bond is 2.1%. The expected return on the S&P 500 Index is 7%.
Taxation:
ExFed pays corporate income tax at the rate of 30%. However, the effective corporate income tax rate on profits from Fameko’s North American operations will be 35%.

Required:

i) Compute the equity beta of ExFed. (3 marks)

ii) Derive an appropriate equity beta for Fameko’s U.S. subsidiary. (4 marks)

iii) Using the capital asset pricing model or the Modigliani and Miller Proposition II with tax, compute an appropriate cost of equity for Fameko’s U.S. subsidiary. (3 marks)

Answer

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Tags: Beta calculation, CAPM, Cost of Equity, Discount rate, Risk Management
Level: Level 2

Topic: Cost of capital, Portfolio theory and the capital asset pricing model (CAPM)
Series: NOV 2020

FM – Nov 2019 – L2 – Q1b – Cost of capital

Calculate the weighted average cost of capital using the dividend valuation model and capital asset pricing model.

Question

Required: Estimate the company’s weighted average cost of capital using:
i) The dividend valuation model.
ii) The capital asset pricing model.

State clearly any assumptions that you make. Under what circumstances these models would be expected to produce similar values for the weighted average cost of capital? (10 marks)

Answer

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Tags: Capital Asset Pricing Model, Cost of Debt, Cost of Equity, Dividend Valuation Model, Weighted Average Cost of Capital
Level: Level 2

Topic: Cost of capital
Series: NOV 2019

FM – Nov 2017 – L2 – Q2a – Cost of capital

Calculate Zaytuna Ltd's Weighted Average Cost of Capital (WACC).

Question

Existing capital structure:

Issued ordinary shares-12,000,000 GH¢12,000
Retained earnings GH¢4,000
6% Preference shares GH¢2,000
9% Debenture repayable 2018 GH¢6,000
Total GH¢24,000

Details:

9% Debenture: Issued in 2008 at par, Current price GH¢92, A similar issue if made now would require to be at GH¢90.
Preference Shares: Preference shares have a par value of GH¢1 and were originally issued at 92p per share, Current price 43p, A similar issue if made now would require to be 40p per share.
Ordinary Share: The market price of an ordinary share is GH¢7.00, GH¢6 million in dividends were paid this year which represented 75% of earnings, Earnings are expected to grow at an annual rate of 5%, If new ordinary shares were issued now, costs incurred would represent 25p per share and a reduction below market value of 50p per share would also be made.
Corporate tax rate is 25%

Required:
Calculate Zaytuna Ltd’s Weighted Average cost of capital. (15 marks)

Answer

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Tags: Cost of Debt, Cost of Equity, Weighted Average Cost of Capital
Level: Level 2

Topic: Cost of capital
Series: NOV 2017

FM – MAY 2018 – L2 – Q3 – Cost of capital | Introduction to Investment Appraisal

Involves the calculation of the cost of various sources of capital, the weighted average cost of capital (WACC), and the net present value (NPV) of a proposed project, as well as an explanation of transaction and economic exposures and methods of mitigating transaction exposure.

Question

a) Okechukwu Ltd is financed by three types of capital:

i) 1 million 50p ordinary shares each having a current market value of GH¢5.20 cum div. The current dividend, which is due to be paid shortly, is 20p per share. The dividend has grown steadily in the past at a compound annual rate of 15% and is generally expected to continue doing so indefinitely.
ii) 200,000 GH¢1 irredeemable 8% preference shares, each having a current market value of 50p ex div.
iii) GH¢2 million 10% debentures, redeemable in 20 years at a price of 110. The current market value is 80 ex int.

Required:

Evaluate the viability of the new project using appropriate computations.
(15 marks)

b) Foreign currency risk can be managed to reduce or eliminate the risk. Measures to reduce currency risk are known as hedging.

Required:

i) Explain Transaction and Economic Exposure.
(5 marks)

ii) Explain FIVE ways of mitigating transaction exposure.
(5 marks)

Answer

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Tags: Cost of Equity, Debentures, Economic Exposure, NPV, Preference shares, Transaction Exposure, WACC
Level: Level 2

Topic: Cost of capital, Introduction to Investment Appraisal
Series: MAY 2018

FM – MAY 2018 – L2 – Q2 – Cost of capital

This question involves calculating the cost of equity, WACC before and after a bond issue, the ex-rights price, and evaluating the impact of a rights issue on a shareholder's wealth.

Question

Required:

i) Determine the cost of equity capital of the company.
(4 marks)

ii) Calculate the weighted average cost of capital of Vista Hotel in the following circumstances:

Before the new issue of bonds takes place;
(3 marks)
After the new issue of bonds takes place.
(3 marks)

Required:

i) Calculate the theoretical ex-rights price of Moorgate’s equity shares.
(4 marks)

ii) Calculate the theoretical value of a Moorgate right, before the shares sell ex-rights.
(3 marks)

The chairman assures him that his wealth will not be reduced because of the rights issue, as long as the shareholder takes appropriate action.

Required:

Prepare a statement showing the effects of the right issue on this particular shareholder’s wealth, assuming:

i) He sells all the rights.
(3 marks)

ii) He exercises one half of the rights and sells the other.
(3 marks)

iii) He does nothing.
(2 marks)

Answer

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Tags: Cost of Equity, Rights Issue, Shareholder Wealth, Weighted Average Cost of Capital (WACC)
Level: Level 2

Topic: Cost of capital
Series: MAY 2018

Question Tag: Cost of Equity

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