Weighted Average Cost of Capital (WACC)

FM – Nov 2023 – L2 – Q4 – Capital structure | DCF: Risk and uncertainty

Explain systematic, business, and financial risk; compute expected NPV for projects; and discuss traditional and Modigliani-Miller views on gearing and WACC.

Question

a) Understanding risk is key for a robust risk and control environment in modern business organisations.
Required:
In the light of the above, explain the following:
i) Systematic risk (2 marks)
ii) Business risk (2 marks)
iii) Financial risk (2 marks)

b) Quantum Investment Ltd in the past has been concentrating all its investments in one project that performed badly consistently over the past few years. They have therefore decided to adopt a diversification strategy by investing in projects A, B, and C. The table below presents the Net Present Value (NPV) of the projects under different states of the economy.

State of Economy	Probability	Project A	Project B	Project C
Bad	0.2	GH¢10 million	GH¢12 million	GH¢15 million
Average/Normal	0.5	GH¢20 million	GH¢22 million	GH¢30 million
Good	0.3	GH¢35 million	GH¢40 million	GH¢45 million

The company has GH¢200 million for investments in these three projects:
Project A = GH¢40 million
Project B = GH¢60 million
Project C = GH¢100 million

Required:
Compute the expected NPV for each of the three projects. (9 marks)

c) In capital structure decisions, there are two views of gearing and weighted average cost of capital (WACC): the traditional view and the Modigliani-Miller view.
Required:
Explain the two views with respect to gearing and WACC. (5 marks)

Answer

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Tags: Business risk, Financial risk, Gearing, Net Present Value (NPV), Systematic risk, Weighted Average Cost of Capital (WACC)
Level: Level 2

Topic: Capital structure, DCF: Risk and uncertainty
Series: NOV 2023

FM – AUG 2022 – L2 – Q1 – Cost of capital

Evaluates the objectives of public sector institutions and the calculation of cost of capital components.

Question

a) Public Sector Institutions exist generally not to make business profit. In view of this, there are other objectives that such sectors aspire to achieve in the performance of their functions.

Required:
i) Explain THREE (3) core objectives of Public Sector Institutions. (8 marks)
ii) Distinguish between financial objectives and non-financial objectives of a firm. (2 marks)

b) Baaday Company Ltd is a Ghanaian registered company engaged in the importation and exportation of general goods. The company issued GH¢600 million bonds at a coupon of 25% per annum. The bonds are irredeemable. Baaday Company Ltd pays a tax rate of 25% and the issue cost is 2% on the value of the bonds issued, which is tax-deductible. Additionally, the company has sold GH¢900 million worth of shares, and the issue cost for the shares is 5% of the value of the shares issued, which is also tax-deductible. The Company shareholders require a return of 30% per annum.

Required:
i) Calculate the cost (in percentage terms) of servicing the bonds. (3 marks)
ii) Calculate the amount raised from the sale or issue of the shares. (2 marks)
iii) Compute the amount the company should earn annually to be able to meet the return expectation of the suppliers of funds. (2 marks)
iv) Compute the Weighted Average Cost of Capital (WACC) for Baaday Company Ltd. (3 marks)

Answer

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Topic: Cost of capital
Series: AUG 2022

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 – MAY 2019 – L2 – Q2a – Capital structure

Calculate the current market capitalization of M&E Ltd and the Weighted Average Cost of Capital (WACC) prior to financing a new project.

Question

Question:
M&E Ltd, recognized as the leader in steel manufacturing, has received an invitation to supply steel for the construction of rail lines to connect the ECOWAS countries, starting from Nigeria. The contract will be for 10 years, and management is considering appraising the investment to enable them to present their proposals for the contract. The following information was extracted from the recently published accounts of M&E Ltd:

	GH¢ ‘000
Equity Shares (1,000,000 shares)	70,000
15% Preference shares	50,000
10% (Bonds irredeemable)	30,000
Total	150,000

The Treasury unit of M&E Ltd has estimated that it will require GH¢ 10 million to finance the new project. The total amount would be raised through 10% Irredeemable bonds at the current market price. The cost of Preference shares and Bonds will not change, but equity shareholders will demand an increase of 20% on the current cost of equity.

M&E Ltd has a beta of 0.8, the market risk premium for the steel industry is 6.25%, and the Government of Ghana Bond rate is 20%. The current market price for Irredeemable Bonds of GH¢1,000 nominal value is GH¢850.

M&E Ltd’s dividend policy is to pay constant dividends, and this policy will not change in the foreseeable future. The recent dividend paid was GH¢20 per share. M&E Ltd is a Free Zones Company and therefore pays tax at a rate of 8%.

Required:

i) Calculate the current market capitalization of M&E Ltd. (5 marks)

ii) Calculate the Weighted Average Cost of Capital (WACC) prior to the consideration of the finance for the proposed project. (9 marks)

(Total: 14 marks)

Answer

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Tags: Beta, Bonds, Equity, Market capitalization, Market risk premium, Preference shares, Weighted Average Cost of Capital (WACC)
Level: Level 2

Topic: Capital structure
Series: MAY 2019

FM – Nov 2023 – L2 – Q4 – Capital structure | DCF: Risk and uncertainty

Explain systematic, business, and financial risk; compute expected NPV for projects; and discuss traditional and Modigliani-Miller views on gearing and WACC.

Question

State of Economy	Probability	Project A	Project B	Project C
Bad	0.2	GH¢10 million	GH¢12 million	GH¢15 million
Average/Normal	0.5	GH¢20 million	GH¢22 million	GH¢30 million
Good	0.3	GH¢35 million	GH¢40 million	GH¢45 million

The company has GH¢200 million for investments in these three projects:
Project A = GH¢40 million
Project B = GH¢60 million
Project C = GH¢100 million

Required:
Compute the expected NPV for each of the three projects. (9 marks)

Answer

Find Related Questions by Tags, levels, etc.

Tags: Business risk, Financial risk, Gearing, Net Present Value (NPV), Systematic risk, Weighted Average Cost of Capital (WACC)
Level: Level 2

Topic: Capital structure, DCF: Risk and uncertainty
Series: NOV 2023

FM – AUG 2022 – L2 – Q1 – Cost of capital

Evaluates the objectives of public sector institutions and the calculation of cost of capital components.

Question

a) Public Sector Institutions exist generally not to make business profit. In view of this, there are other objectives that such sectors aspire to achieve in the performance of their functions.

Required:
i) Explain THREE (3) core objectives of Public Sector Institutions. (8 marks)
ii) Distinguish between financial objectives and non-financial objectives of a firm. (2 marks)

Answer

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Topic: Cost of capital
Series: AUG 2022

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

Find Related Questions by Tags, levels, etc.

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 – MAY 2019 – L2 – Q2a – Capital structure

Calculate the current market capitalization of M&E Ltd and the Weighted Average Cost of Capital (WACC) prior to financing a new project.

Question

	GH¢ ‘000
Equity Shares (1,000,000 shares)	70,000
15% Preference shares	50,000
10% (Bonds irredeemable)	30,000
Total	150,000

Required:

i) Calculate the current market capitalization of M&E Ltd. (5 marks)

ii) Calculate the Weighted Average Cost of Capital (WACC) prior to the consideration of the finance for the proposed project. (9 marks)

(Total: 14 marks)

Answer

Find Related Questions by Tags, levels, etc.

Tags: Beta, Bonds, Equity, Market capitalization, Market risk premium, Preference shares, Weighted Average Cost of Capital (WACC)
Level: Level 2

Topic: Capital structure
Series: MAY 2019

Question Tag: Weighted Average Cost of Capital (WACC)

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FM – Nov 2023 – L2 – Q4 – Capital structure | DCF: Risk and uncertainty

Explain systematic, business, and financial risk; compute expected NPV for projects; and discuss traditional and Modigliani-Miller views on gearing and WACC.

FM – AUG 2022 – L2 – Q1 – Cost of capital

Evaluates the objectives of public sector institutions and the calculation of cost of capital components.

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.

FM – MAY 2019 – L2 – Q2a – Capital structure

Calculate the current market capitalization of M&E Ltd and the Weighted Average Cost of Capital (WACC) prior to financing a new project.

FM – Nov 2023 – L2 – Q4 – Capital structure | DCF: Risk and uncertainty

Explain systematic, business, and financial risk; compute expected NPV for projects; and discuss traditional and Modigliani-Miller views on gearing and WACC.

FM – AUG 2022 – L2 – Q1 – Cost of capital

Evaluates the objectives of public sector institutions and the calculation of cost of capital components.

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.

FM – MAY 2019 – L2 – Q2a – Capital structure

Calculate the current market capitalization of M&E Ltd and the Weighted Average Cost of Capital (WACC) prior to financing a new project.

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Question Tag: Weighted Average Cost of Capital (WACC)

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FM – Nov 2023 – L2 – Q4 – Capital structure | DCF: Risk and uncertainty

Explain systematic, business, and financial risk; compute expected NPV for projects; and discuss traditional and Modigliani-Miller views on gearing and WACC.

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FM – AUG 2022 – L2 – Q1 – Cost of capital

Evaluates the objectives of public sector institutions and the calculation of cost of capital components.

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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.

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FM – MAY 2019 – L2 – Q2a – Capital structure

Calculate the current market capitalization of M&E Ltd and the Weighted Average Cost of Capital (WACC) prior to financing a new project.

You're reporting an error for "FM – MAY 2019 – L2 – Q2a – Capital structure"

FM – Nov 2023 – L2 – Q4 – Capital structure | DCF: Risk and uncertainty

Explain systematic, business, and financial risk; compute expected NPV for projects; and discuss traditional and Modigliani-Miller views on gearing and WACC.

You're reporting an error for "FM – Nov 2023 – L2 – Q4 – Capital structure | DCF: Risk and uncertainty"

FM – AUG 2022 – L2 – Q1 – Cost of capital

Evaluates the objectives of public sector institutions and the calculation of cost of capital components.

You're reporting an error for "FM – AUG 2022 – L2 – Q1 – Cost of capital"

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.

You're reporting an error for "FM – MAY 2018 – L2 – Q2 – Cost of capital"

FM – MAY 2019 – L2 – Q2a – Capital structure

Calculate the current market capitalization of M&E Ltd and the Weighted Average Cost of Capital (WACC) prior to financing a new project.

You're reporting an error for "FM – MAY 2019 – L2 – Q2a – Capital structure"

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