INDIVIDUAL ASSIGNMENT
FINANCIAL MANAGEMENT (ACC209)
Submitted to: Ahmed Salih
Date: 2nd May 2013
Student Name: Shahuma Khalid
Student ID No: 7427
Bachelors of Business
Faculty of Management and Computing
Individual Assignment
Humble Manufacturing is interested in measuring its overall cost of capital. The firm is in
the 40% tax bracket. Current investigation has gathered the following data:
Debt: The firm can raise an unlimited amount of debt by selling $1,000-parvalue, 10%
coupon interest rate, 10-year bonds on which annual interest payments will be made.
To sell the issue, an average discount of $30 per bond must be given. The firm must also
pay flotation costs of $20 per bond.
Preferred stock: The firm can sell 11% (annual dividend) preferred stock at its $100-pershare par value. The cost of issuing and selling the preferred stock is expected to be $4
per share. An unlimited amount of preferred stock can be sold under these terms.
Common stock: The firm’s common stock is currently selling for $80 per share. The firm
expects to pay cash dividends of $6 per share next year. The firm’s dividends have been
growing at an annual rate of 6%, and this rate is expected to continue in the future. The
stock will have to be underpriced by $4 per share, and flotation costs are expected to
amount to $4 per share. The firm can sell an unlimited amount of new common stock
under these terms.
Retained earnings: The firm expects to have $225,000 of retained earnings available in
the coming year. Once these retained earnings are exhausted, the firm will use new
common stock as the form of common stock equity Financing.
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Individual Assignment
a. Calculate the specific cost of each source of financing. (Round to the nearest 0.1
%.)
Answer) Cost of Debt
𝐾𝑑 =
$1000 − (1000 − 20 − 20)
10
950 + 1000
2
(1000 × 10%) +
𝐾𝑑 =
$1000 − 950
10
950 + 1000
2
100 +
𝐾𝑑 =
𝐾𝑑 =
$1000 − 𝑁𝑑
𝑛
𝑁𝑑 + 1000
2
𝐼+
105
975
𝐾𝑑 = 10.8
After tax
𝐾𝑖 = 𝐾𝑑 × (1 − 𝑇)
𝐾𝑖 = 10.8 × (1 − 0.6)
=6.4
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Individual Assignment
Cost of preferred stock
𝐷𝑝
𝑁𝑝
𝑘𝑠 =
𝐾𝑠 =
11
(100−4)
=11.4
Cost of common stock
𝐾𝑠 =
𝐷1
+𝑔
𝑃𝑜
11
+ 6%
80
=13.5
Cost of new common stock
𝐾𝑠 =
𝐷1
+𝑔
𝑃𝑜
11
+ 6%
(80 − 4 − 4)
=14.3
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Individual Assignment
b. The firm uses the weights shown in the following table, which are based on
target capital structure proportions, to calculate its weighted average cost of
capital. (Round to the nearest 0.1 %.)
Source of Capital
Weight
Long-term debt
40%
Preferred Stock
15
Common stock Equity
45
Total
100
Answer) Weighted Average Cost of Capital
Source of Capital
Long term Debt
Preferred
Common stock
total
Cost of Capital
6.4
11.4
13.5
Weight
0.40
0.15
0.45
WACC
2.5
1.8
6.1
10.4
(1) Calculate the single break point associated with the firm’s financial situation.
(Hint: This point results from exhaustion of the firm’s retained earnings.)
Answer)
𝐵𝑝Common equity = 𝐵𝑝𝑗 =
𝐴𝑓𝑗
𝑊𝑗
225000
0.45
= 500000
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Individual Assignment
(2) Calculate the weighted average cost of capital associated with total new
financing below the break point calculated in part (1).
Weighted Average Cost of Capital for Ranges of total new financing of Humble
manufacturing
Range of total new financing
0 - 225000
Source of Capital
Long term Debt
Preferred
Common stock
total
Cost of Capital
6.4
11.4
13.5
Weight
0.40
0.15
0.45
WACC
2.5
1.8
6.1
10.4
Cost of Capital
6.4
11.4
14.3
Weight
0.40
0.15
0.45
WACC
2.5
1.8
6.4
10.7
< 500000
Source of Capital
Long term Debt
Preferred
Common stock
total
(3) Calculate the weighted average cost of capital associated with total new
financing above the breakpoint calculated in part (1).
> 500000
Source of Capital
Debt
Preferred
Common stock
total
Cost of Capital
6.4
11.4
14.6
Weight
0.40
0.15
0.45
WACC
2.5
1.8
6.6
10.9
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Individual Assignment
c. Define cost of capital and explain the key assumptions made relating to risk in
isolate the basic structure of the cost of capital
Answer) the cost of capital is the rate of return that a firm must earn on the
projects in which it invests to maintain the market value of its stock. The cost of
capital provides benchmark against which the potential rate of return on an
investment is compared.
The cost of capital is a dynamic concept affected by a variety of economic and
firm-specific factors. To isolate the basic structure of the cost of capital, we make
some key assumptions relative to risk and taxes:
1. Business risk—holding business risk constant assumes that the acceptance
of given project leaves the firm’s ability to meet its operating expenses
unchanged. (Gitman)
2. Financial risk—holding financial risk constant assumes that the acceptance
of a given project leaves the firm’s ability to meet its required financing
expenses unchanged. By doing this it I possible to more easily calculate the
firm’s cost of capital, which is a factor taken into consideration in evaluating
new projects.
d. Explain why the cost of capital is measured on an after-tax basis why is use of a
weighted average cost of capital rather the cost of the specific source of funds
recommended?
Answer) The cost capital is measured on after tax basis in order to be consistent
with the capital budgeting framework. The only component of the capital that
actually requires a tax adjustment is the cost of debt, since interest is on debt,
since interest is on debt is treated as a tax-deductible expenditure. Measuring
the cost of debt on an after-tax basis reduces the cost. The weighted average
cost is recommended over the cost of the source of fund used for the project.
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Individual Assignment
The interrelatedness of financing decision assuming the presence of a target
capital structure is reflected in the weighted average cost of capital.
e. Explain briefly five methods used to evaluate capital investment projects
Answer)
1. Payback: This calculates the number of years it will take to recoup the cash spent
on a project. A criticism of payback is that the time value of money is not
considered and the cash flows over the entire life of the project are not
considered. All else being equal, shorter payback periods are preferable to
longer payback periods. Payback period is widely used because of its ease of use.
2. Net present Value: This method discounts the project’s future cash flows by a
predetermined rate, such as the targeted or needed rate. If the cash flows
discounted by the targeted rate exceed the cash investment, the project is
accepted. That is, the project provides the targeted return or more
3. Internal Rate of Return: This method does consider the time value of money and
looks at the cash flows over the entire life of the project. The technique
computes the rate that will discount the future cash flows to be equal to the
cash outlay for the project. IRR calculations are commonly used to evaluate the
desirability of investments or project. The higher a project’s IRR, the more
desirable it is to undertake the project.
4. Accounting Rate of Return or Return on Investment: This approach looks at the
increase in accounting profit compared to the increased investment. This
approach also ignores the time value of money. ARR is a percentage return. If
the ARR is equal to or greater than the required rate of return, the project is
acceptable. If it is less than the desired rate, it should be rejected. When
comparing, the higher the ARR, the more attractive the investment.
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Individual Assignment
5. Profitability Index (PI): It is useful tool for ranking projects, because it allows you
to quantify the amount of value created per unit of investment. The ratio is
calculated as follows:
Profitability index = PV of future cash flows / Initial Investment
As the value of the profitability index increases, so does the financial
attractiveness of the proposed project. Rules for selection or rejection of a
project:

If PI > 1 then accept the project

If PI < 1 then reject the project
(Ranking Investment proposals)
(Understanding the Weighted Average Cost of Capital (WACC))
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Individual Assignment
Bibliography
Gitman, L. J. (n.d.). Principles of Managerial Finance. New Jersey: Prentice Hall.
Ranking Investment proposals. (n.d.). Retrieved April 27, 2013, from www.boundless.com:
https://www.boundless.com/finance/capital-budgeting/introduction-to-capitalbudgeting/ranking-investment-proposals/
Understanding the Weighted Average Cost of Capital (WACC). (n.d.). Retrieved April 27, 2013,
from Qfinance website: http://www.qfinance.com/balance-sheetschecklists/understanding-the-weighted-average-cost-of-capital-wacc
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