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2021 Learning guide - Cost of Capital MM
Financial Management 200 (University of Johannesburg)
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College of Business and Economics
School of Accountancy
Department of Accountancy
Learning Guide: Cost of Capital
Financial Management 200
FMA200
Ms Mariska McKenzie
Mr Thabiso Madiba
2021
Copyright © University of Johannesburg, South Africa
Printed and published by the University of Johannesburg
© All rights reserved.
Apart from any fair dealing for the purpose of research, criticism or review as permitted under the Copyright Act 98 of
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in any form or be published, redistributed or screened by any means electronic, photocopying, recording or otherwise
without the prior written permission of the University of Johannesburg.
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Section A: Learning Outcomes
After working through this chapter, you should be able to:

Understand the concept of the weighted average cost of capital (WACC)

Determine the cost of debt

Determine the cost of preference share capital

Calculate the cost of equity using the dividend growth model and the CAPM
approach

Understand the practical issues of estimating the CAPM parameters

Understand how a firm’s capital structure affects a firm’s WACC

Calculate firm’s weighted average cost of capital (WACC)
Section B: FREQUENCY OF TESTING & EXAM POSSIBILITIES
Cost of capital is a basis for many other topics such capital budgeting to be done in 3 rd
year, Free cash flow valuations done in CTA. The understanding of this topic is crucial
and it is tested very often either on its own or as part of other topics.
Section C: LITERATURE

Correia C et al, Financial Management 9th Edition Chapter 7

You may be required to know important formulas that are used in these chapters.
No formula sheets will be distributed
Section D: OBJECTIVE TEST

Explain in your own words what the point of calculating the cost of capital is (3)
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Section E: TUTORIAL QUESTIONS
Tutorial Question
(34 Marks)
Sapitec Bank is South Africa’s fastest growing bank. They are focused on the middle to lower
income groups. They strive to simplify banking and have developed an all-inclusive banking
solution. What has made them prosper is that they ensure that they do whatever they can to
make banking accessible to everyone. They have also reduced unnecessary paperwork which
has resulted in a reduction of admin fees which allows them to pass on the cost-saving to the
customer.
th
Sapitec recently unveiled their 500 branch in Morning Glen. They then unveiled their plans to
double the number of branches they have by 2025. This project will require significant capital
over the period. After a capital budget was performed, the Financial Director wanted to make
sure that the internal rate of return (IRR) of the project was indeed greater than the cost of
capital. He has asked you to calculate the cost of capital. The following Statement of Financial
Position and notes were made available to you:
.
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SAPIT EC BANK
Statement of Financial Position
As at 28 February 2019
Notes
2019
R'000
458,445
2,841,918
9,963,966
1,067,688
Fixed Assets
Cash and Cash Equivalents
Loans and Advances to clients
Other Current Assets
Total Assets
14,332,017
Equity and Liabilities
Ordinary Share Capital and Premium
Preference shares and Premium
Retained Earnings
Liabilities
Bonds
Debentures
Customer Deposits
Other Current Liabilities
Total Equity and Liabilities
1
2
1,918,677
258,969
1,272,867
3,450,513
3
4
1,455,600
2,042,500
6,844,283
539,121
10,881,504
14,332,017
Page 2
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Note 1
•
The share premium equated to R1,900,677,000. The shares have a par value of R1 per
share.
•
Sapitec shares were trading at R168 at the close of business on 28 Feb 2019.
Note 2
•
11% preference shares were issued at a par value of R10. The preference shares are
cumulative, non-redeemable preference shares.
Sapitec has 500,000,000
authorised
preference shares and 200,000,000 issued preference shares. Preference shares were
trading at R9 per share at the close of business on 28 Feb 2019.
Note 3
•
The bonds were issued with the following terms:
o
9.6% bonds were issued at par with a semi-annual; coupon payment
o
The bonds will be redeemed in 5 years’ time at a premium of 5% of the nominal
value.
•
Management could not determine the market related yield of the bonds, so they decided
to benchmark the rate to the risk-free rate to be used. The Financial Director was happy to
use a before tax premium of 2.5% on the risk-free rate to represent the market related
interest on the bonds.
Note 4
•
8% Debentures were issued to selected lenders on 28 February 2019. This was because
special repayment terms were negotiated with the particular lenders as not everyone was
happy with the repayment terms proposed. The repayment terms have been agreed on as
follows:
o
The debenture will be settled in 5 years’ time
o
The par value of R2,150,000 will be paid back at a premium of 40% at the end of
the 5 year term.
•
The debentures were issued at a discount of 5% of the par value.
Page 3
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Additional information
•
The company tax rate is 28%
•
The Financial Director searched the Reserve Bank website and found the following
information for retail government bonds:
Name
Coupon
Market Yield
Maturity
R158
5.93%
6.71%
15 September 2022
R203
7.65%
8.42%
15 September 2025
When the head of the Monetary Policy Committee (MPC) and Governor of the Reserve
•
Bank announced that interest rates were going to remain stable at the last MPC meeting,
the returns of the market increased by 2% and the returns of Sapitec Bank increased
by only 1.7%.
The market risk premium as per a recent study was 6.2%.
•
REQUIRED
(a)
(b)
MARKS
In your own words, give three alternative explanations of what the cost of
capital is.
3
Calculate the cost of capital of Sapitec Bank as at 1 March 2019. Show
all calculations.
31
TOTAL MARKS
34
Section F: ASSIGNMENTS
Assignment
(25 MARKS)
Kuvaka Ltd (“Kuvaka”) is a South African company that owns and manages property.
Kuvaka is highly successful and is listed on the Johannesburg Stock Exchange. The
directors of Kuvaka are considering whether or not to embark on a development of
residential apartments in Midrand. The apartments will be rented out to tenants once the
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development project is completed. The development will cost R80 million and yield an
annual pre-tax return of 16%. The directors have asked for your advice on whether they
should embark on this project. They have provided you with the following information:
Statement of Financial Position of Kuvaka Ltd as at 31 December 2016
Note
R
Million
ASSETS
Property, plant and equipment
400
Trade and other receivables
20
Cash and cash equivalents
60
480
EQUITY AND LIABILITIES
Ordinary share capital
11% Cumulative non-redeemable preference shares
8% Loan: ABSA Bank
9% Bonds (par value)
1
2
3
4,5
70
100
80
230
480
Notes
1. The company has an authorised share capital of 5 000 000 no par value shares. On the 31st
of December 2016 Kuvaka, had 800 000 ordinary shares in issue. The Kuvaka shares
traded at R125 per share on the JSE on the 31st of December 2016.
2. All preference shares were issued at the incorporation of the company at a par value of R20
each. On the 31st of December 2016 the preference shares traded at R18 per share. The
company has sufficient authorised share capital available to issue additional preference
shares. All preference dividends due to shareholders were paid as at 31 December 2016.
3. Kuvaka’s property serves as security for the ABSA loan. ABSA have indicated that they
would be willing to increase the loan facility to Kuvaka, the interest rate on the loan would
however increase to 8,25%.
4. The 9% bonds were issued at par value on 1 January 2016. The coupon payments are
made semi-annually. The bonds will be redeemed on the 31 st of December 2019 at a
discount of 10% on the par value.
5. On 31 December 2016 the current market related interest rate available on bonds similar to
the bonds issued by Kuvaka amounts to 10,5% per year compounded once per year.
Additional information
-
The company tax rate is 28%.
Round all figures to 2 decimal places.
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-
The market risk premium on investments in property companies listed on the JSE is 7%.
The beta of Kuvaka was determined to be 0,8.
The yield on the R208 is determined through bond auctions and can be found at the SARB
(South African Reserve Bank)
The Statement of Financial Position has been prepared on the amortised cost basis.
REQUIRED
MARKS
(a)
Calculate the weighted average cost of capital of Kuvaka Ltd as at
31 December 2016. Show all calculations
20
(b)
Advise the directors of Kuvaka Ltd on whether they should
embark on the project in Midrand or not. Support your answer with
calculations.
3
(c)
Explain why the interest rate on the ABSA loan is lower than the
interest paid on the bonds.
2
TOTAL MARKS
25
Section G: PRE-CLASS PREPARATION
Weighted Average Cost of Capital (WACC)
11
Shar
e
What it is:
Weighted average cost of capital (WACC) is the average rate of return a
company expects to compensate all its different investors. The weights are the
fraction of each financing source in the company's target capital structure.
How it works (Example):
Here is the basic formula for weighted average cost of capital:
WACC = ((E/V) * Re) + [((D/V) * Rd)*(1-T)]
E = Market value of the company's equity
D = Market value of the company's debt
V = Total Market Value of the company (E + D)
Re = Cost of Equity
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Rd = Cost of Debt
T= Tax Rate
A company is typically financed using a combination of debt (bonds) and equity
(stocks). Because a company may receive more funding from one source than
another, we calculate a weighted average to find out how expensive it is for a
company to raise the funds needed to buy buildings, equipment, and inventory.
Let's look at an example:
Assume newly formed Corporation ABC needs to raise $1 million in capital so it
can buy office buildings and the equipment needed to conduct its business. The
company issues and sells 6,000 shares of stock at $100 each to raise the first
$600,000. Because shareholders expect a return of 6% on their investment, the
cost of equity is 6%.
Corporation ABC then sells 400 bonds for $1,000 each to raise the other
$400,000 in capital. The people who bought those bonds expect a 5% return, so
ABC's cost of debt is 5%.
Corporation ABC's total market value is now ($600,000 equity + $400,000 debt) =
$1 million and its corporate tax rate is 35%. Now we have all the ingredients to
calculate Corporation ABC's weighted average cost of capital (WACC).
WACC = (($600,000/$1,000,000) x .06) + [(($400,000/$1,000,000) x .05) * (10.35))] = 0.049 = 4.9%
Corporation ABC's weighted average cost of capital is 4.9%.
This means for every $1 Corporation ABC raises from investors, it must pay its
investors almost $0.05 in return.
Why it Matters:
It's important for a company to know its weighted average cost of capital as a
way to gauge the expense of funding future projects. The lower a
company's WACC, the cheaper it is for a company to fund new projects.
A company looking to lower its WACC may decide to increase its use of cheaper
financing sources. For instance, Corporation ABC
may issue more bonds instead of stock because it can get the financing more
cheaply. Because this would increase the proportion of debt to equity, and
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because the debt is cheaper than the equity, the company's weighted
average cost of capital would decrease.
Source:
https://investinganswers.com/financial-dictionary/financial-statement-analysis/weightedaverage-cost-capital-wacc-2905
Section H: SELF-ASSESSMENT QUESTIONS
The question bank contains a pool of previous test and exam questions.
After you have studied this topic in detail, attempt the questions in the attached question
bank. You should do these questions before looking at the solution. Only after you have
done the questions properly, should you refer to the solution and mark your answer.
QUESTION 1:
Klimbo Ltd has a target capital structure of 60% equity and 40% debt. The after-tax cost
of future debt is 11% and the cost of new equity is 21%. The financial manager is
currently considering a project with an expected return of 20% which will be financed
from the issue of ordinary shares as all retained income is already budgeted for in more
profitable projects. The company recently issued debentures and, as a result, the
present capital structure is more heavily weighted towards debt.
YOU ARE REQUIRED TO:
(a)
Calculate the weighted average cost of capital.
(b)
State, with reasons, whether the project under consideration should be accepted.
QUESTION 1:
(Suggested Solution)
a)
COMPONENT
WEIGHT
COST
AVERAGE
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Equity
60%
21%
12.60%
Debt
40%
11%
4.40%
100%
17.00%
The weighted average marginal cost of capital is 17%
b)
Yes the project should be accepted. Any project which offers a return greater
than 17% should be accepted, provided that it is in a risk class similar to that of the
business as a whole. The fact that new shares with a component cost of 21% are to be
issued by Kimbo Ltd at this time in order to finance that particular project, is irrelevant.
For all investment decisions the weighted average marginal cost is appropriate as
funding should be seen to emanate from a pool of funds. Linking particular investment
projects of a business to the source of finance being used at the time will lead to
suboptimal decisions.
QUESTION 3:
It is commonly accepted that a crucial factor in the financial decisions of a company,
including the evaluation of capital investment proposals, is the cost of capital. The
following information is available for Otago Ltd:
Current price per share on Securities Exchange
R1.20
Current year’s dividend per share
R0.10
Expected average annual growth rate of dividends
7%
Beta coefficient for Otago Ltd
0.5
In addition, the following information has been established:
Expected rate of return on risk-free securities
8%
Expected return on the market portfolio
12%
YOU ARE REQUIRED TO:
(a)
Explain what is meant by the ‘cost of equity capital’ for a particular company.
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(b)
Calculate the cost of equity capital for Otago Ltd from the data given above, using
the following two alternative methods:
(i) a dividend growth model; and
(ii) the capital asset pricing model.
(c)
State, for each model separately, the main simplifying assumptions made and
express your opinion about whether, in view of these assumptions, the models
yield results that can be used safely in practice.
QUESTION 2:
a)
(Suggested Solution)
The cost of equity capital for a particular company is the rate of return on
investment that is required by the company's ordinary shareholders. The return
consists of both dividend and capital gains (ie. increases in the share price).
The returns are expected future returns, not historical returns, and so the returns
on equity can be expressed as the anticipated dividends on the shares every
year in perpetuity. The cost of equity is then the cost of capital which will equate
the current market price of the share with the discounted value of all future
dividends in perpetuity.
The cost of equity reflects the opportunity cost of investment for individual
shareholders. It will vary from company to company because of the differences
in the business risk and financial or gearing risk of different companies.
b)
i)
Dividend growth model:
r = D1/Po + g
r = 0.10 (1.07)/1.20 + 0.07
ii)
= 0.159,
= say, 0.16 or 16%
Capital Asset Pricing Model:
r = Rf + B(Rm-Rf)
r = 8% + 0.5 (12% - 8%) = 8% + 2%
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Dividend growth model
Assumptions in this model are that:
-
a dividend growth rate can be forecast, and expectations are the same for
all shareholders;
-
dividends will grow at a constant rate;
-
"r" is greater than "g";
-
there is a readily-available current market value for the share, which is
also a 'free-market' price;
None of these assumptions is necessarily correct, and the weakness of assumption (i)
might be particularly damaging to the credibility of the model. However, it might provide
a reasonable approximation of the cost of equity, and a better estimate perhaps than
other cost of equity models.
Capital Asset Pricing Model
The main assumptions in this model are that:

Investors are risk-averse and attempt to minimise the risk for any expected
utility of their end-of-period wealth.

All investors can borrow or lend an unlimited amount at a given risk-free rate
of interest.

Investors have homogeneous expectations about asset returns.

All assets are perfectly divisible and perfectly liquid and there are no
transaction costs.

There are no taxes and market imperfections.

All investors are price takers.

Information in asset markets is costless and simultaneously available to all
shareholders.
None of the assumptions in the model are unacceptable, in spite of their
simplification of reality, but the potential weaknesses are that:

a statistically-reliable beta factor might not exist for some companies;

the beta factor is calculated from historical data about dividends and capital
growth. Historical data might not provide a representative guide to investors'
expectations about a company's future, which ought to be the main basis for
the investment decisions.
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QUESTION 3:
Sincro Ltd’s capital structure is as follows:
Debt
35%
Preference shares
15%
Ordinary share equity
50%
The after-tax cost of debt is 6.5%; the cost of preference shares is 10%;and the cost of
ordinary share equity is 13.5%.
As an alternative to the existing capital structure for Sincro, an outside consultant has
suggested the following modifications:
Debt
60%
Preference shares
5%
Ordinary share equity
35%
Under this new and more debt-oriented arrangement, the after-tax cost of debt is 8.8%;
the cost of preference shares is 11%; and the cost of equity is 15.6%.
YOU ARE REQUIRED TO:
(a)
Calculate Sincro’s existing weighted average cost of capital.
(b)
Recalculate Sincro’s weighted cost of capital, using the capital structure
suggested by the consultant.
(c)
Discuss the issues which are pertinent to the choice between the two alternative
capital structures.
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QUESTION 3:
a)
(Suggested Solution)
Existing weighted cost of capital:
COMPONENT
COMPONENT WEIGHT WEIGHTED
Debt (Rd)
Preference shares (Rp)
Ordinary shares (RE)
COST
6.5%
10.0%
35.0%
15.0%
COST
2.28%
1.50%
13.5%
50.0%
6.75%
10.53%
b)
Weighted cost of capital under consultant's plan:
COMPONENT
COMPONENT WEIGHT WEIGHTED
Debt (Rd)
Preference shares (Rp)
Ordinary shares (RE)
COST
8.8%
11.0%
60.0%
5.0%
COST
5.28%
0.55%
15.6%
35.0%
5.46%
11.29%
c)
The existing capital structure is better than the plan presented. Even though the
plan has more relatively cheap debt, the increased costs of other forms of
financing, noticeably the equity capital more than offset this factor. This results
from ordinary shareholders perceiving the additional risk to which they will be
exposed by the higher proportion of debt in the capital structure.
QUESTION 4
(40 MARKS)
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You are the partner in charge of the financial advisory services appointment of a listed
company, Valpree Limited, a manufacturer and supplier of bottled water. The company
started its operations 10 years ago and has shown stable growth ever since. The
company grew especially well in certain Africa countries due to the increase in mining
activities polluting the water in Africa.
In an attempt to diversify, the company decided to introduce a new product line, flavored
water. This new product line was expected to first be tested in the market for a period of
six months before the final decision would be taken to implement this new product line
permanently.
Mr.Aquabon, the financial director of Valpree was unsure whether to implement this new
project line in the first place, stating that: "Flavoured water won't work in Africa, that is
for sure! People in Africa don't have money for luxuries like flavoured water. It is
ridiculous!"
In another statement Mr.Aquabon said that Valpree always uses the current market
value as optimal capital structure in calculating WACC.
An extract of the statement of financial position as on 30 November 20x7 was as
follows:
R
'000
Equity
Share capital
Share premium
Retained earnings
Shareholders loan
12 500
1 200
25 690
2 000
Liabilities
Non-current liabilities
Preference shares (13%)
Debentures (16, 5%) (non redeemable)
Long-term loan (18%)
7 500
18 700
15 300
Current liabilities
Trade creditors
Bank overdraft
3 651
1 765
Additional information
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1. Ordinary shares are presently trading at R 13,50 per share. The par value of the
shares is R10 each.
2. Preference shares have a par value of R5 per share. The preference shares are
redeemable within two months at a premium of 11%.
3. R200 nominal debentures interest is payable on 31/05 and 30/11 every year.
The market value of debentures at reporting date is R252.
4. The interest on the long-term loan is payable at the end of each year for the next 8
years. The creditors gave Valpree the option to settle the loan on 01/12/2007 for R14
563 000. Valpree did not accept the option.
5. Trade creditors fluctuate from month to month and are not considered as part of the
permanent financing
6. Bank overdraft is the result from recent cash flow problems incurred by the company.
The problems are expected to be temporary and Valpree is obligated to settle the
overdraft within the next 2 months.
8. Other information
RSA 153: 11,61%
Beta = 1,6
Tax rate: 28%
Rm = 14,17%
REQUIRED
a)
Explain what is the cost of capital of a company?
(3)
b)
What is meant by the "pooling of funds" principle?
c)
Calculate the WACC of Valpree Limited. Give reasons for your calculations and
inclusions/exclusions in the WACC calculation.
(25)
d)
Advise Valpree Limited on additional factors they need to take into account before
they accept the new project line.
(6)
e)
Explain what impact risks will have on the cost of capital
NOTE:
Round all calculations off to four decimal places
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(2)
(4)
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QUESTION 4
a)
SUGGESTED SOLUTION
What is the cost of capital of a company?
 The minimum return that a project must offer before it can be accepted. 
 It is the return rate that is required by capital suppliers. 
 The opportunity cost of investing in that project. 
 = Cost of equity + Cost of debt + Cost of preference shares. 
 It shows the risk of the company. 
 It is the weighted average cost of required returns of providers of long-term or
permanent capital 
b) Pooling of funds
 The pooling of funds means that the projects are not financed from one
specific source.  When evaluating projects, we comparing the IRR to WACC
based on the funds pooled.
 All projects expected are financed from a joined pool of funds that includes all the
sources in the capital structure. [in their current ratio to prevent suboptimal
decision making]
c) Calculation of WACC
Share Capital
 Market value:
R12 500 000/R10 = 1 250 000 shares 
1 250 000 x R13, 50  = R16 875 000
 Cost:
CAPM/SML Approach
(Re) = Rf + B(Rm - Rf)
= 11,61 + 1,6 x (14,7 - 11,61)
= 15,706%
= 15,71%
Preference Shares
 Not part of the capital structure of Valpree 
 because redeemable within two months 
 thus not included in WACC 
 Assumption: Preference shares will be proportionately replaced with other
sources of permanent financing 
Debentures
 Debentures are non-redeemable thus = perpetuity 
 Market value:
R18 700 000/R200 = 93 500 debentures x R252
= R23 562 000
 Cost:
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Interest after tax/Market value per share
200 x 16,5% x 72%/252
= 9,4285%
= 9,43%
Long Term Loan
 Market value:
R14 563 000
 Cost:
P/Yr=1
C/Yr=1
PV = 14 563 000
N=8 
FV = 15 300 000
PMT=1 982 880 
 IRR = 14% 
OR
PMT = 2 754 000 
 IRR = 19.23% 
19.23% x 72% = 13.84% 
Trade Creditors
 Not part of capital structure of Valpree
 because not considered part of permanent financing
 thus not included in WACC
 Trade credit don't have any explicit cost
Bank Overdraft
Not part of the capital structure of Valpree
because temporary sources of finance(settle in 2 months)
thus not permanent source of finance
thus not included in WACC
To calculate WACC use the market value as the optimal capital structure according
to Valpree's policy.
Component
Equity
Debentures
Long Term Loan
Market Value
16 875 000
23 562 000
14 563 000
Weight
30,68%
42,84%
26,48%
Conclusion: The WACC of Valpree is 12, 57% (p)
OR
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Cost
15,71%
9,43%
14,0%
Total
4,82%
4,04%
3,71%
12,57% 
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Component
Equity
Debentures
Long Term Loan
Market Value
16 875 000
23 562 000
14 563 000
Weight
30,68%
42,84%
26,48%
Cost
15,71%
9,43%
13,84%
Total
4,82%
4,04%
3,66%
12,52% 
Conclusion: The WACC of Valpree is 12, 52% (p)
(MAX:25)
d) Additional factors(qualitative factors)
 The market and demand for the new product
 Competitors
 Exposure to foreign exchange fluctuations
 The risk of the project
 Additional cost of the project (e.g. flavorings /colorants)
 Licenses for the product
 Knowledge and experience in manufacturing flavoured water
 Impact of the new product line on the present product
 Will they be able to sell the product to their current customers or do they have to
gain new clients
 Any other valid reason 
(max:6)
e) Impact of risk on cost of capital
 In general investors are risk adverse
 thus the higher the risk  the higher the required rate of return wanted by
investors
 That leads to an increase in the cost of equity
 thus leading to an increase in the cost of capital
(max:4)
(TOTAL:40)
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QUESTION 5
(40 MARKS)
You are the recently appointed financial advisor of Boating Adventures Ltd. Boating
Adventures Ltd (BA) is a listed company who manufactures boats, Jet Ski’s and various
other boating equipment. The company was incorporated 10 years ago, and has shown
significant growth since then. The company is currently considered the market leader in
the boating industry.
Boating Adventures Ltd is planning to open various BA Ltd franchises in Africa as they
recently discovered that clients from African countries travel to South Africa for their
boating needs. The financial director, Mr. Y.A. Maha informed you that they will need a
significant amount of capital for the planned expansion. He also informed you that the
acceptance of the project will depend on the outcome of evaluations performed using
the historic cost of capital of the company.
Mr. Y.A. Maha provided you with the following information:
An extract of the balance sheet as at 31 March 2018:
Balance Sheet
Referenc
e
R
Equity
Share Capital (R2 shares)
Share Premium
1
1
200 000
12 650 000
Liabilities
Non-current liabilities
Preference Shares (12%)
Debentures (redeemable)
Long-term Loan (17%)
2
3
4
500 000
2 250 000
3 500 000
Current liabilities
Bank Overdraft
Sundry Creditors
5
6
2 000 000
950 000
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Additional information:
1. Shares are trading on the JSE for R128,50 per share.
2. The preference shares consist of 25 000 non-redeemable preference shares.
Similar preference shares currently trade in the market for R17.14 per share.
3. The debentures are redeemable in 6 years. 20 000 Debentures were issued at
R112.50 each (a discount of 10%) on 31 March 2016. The debentures will carry
interest at 11% of par value per annum, and the par value of the debentures will
be paid in 2 equal installments in 2023 and 2024.
4. The long-term loan relates to a loan that carries interest at 17% per annum and
will be redeemed in full in 10 years. Similar loans currently trade in the market at
prime + 2%.
5. Mr. Y.A. Maha informed you that the bank overdraft will be redeemed in the
following month and will not be used as a source of financing again, due to the
high cost of the overdraft facility.
6. The sundry creditors relate to a loan from one of Boating Adventures well-known
clients which will be settled in 2 months. The loan will however be replaced by a
loan of the same value by the client, which will be settled in the following year
and carries interest at a rate of 12%.
Other information:

The current market value represents the optimal capital structure.

The prime interest rate is currently 15%.
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
An announcement this morning by the Reserve Bank is that the prime interest
rate will increase with 0,5% by the end of business today and will therefore be
applicable for all future borrowings.

The project is expected to be fully implemented within 5 years.

Assume a tax rate of 30%.

Debentures currently trade at an effective cost of 12% p.a.

The required rate of return that shareholders require when investing in a
company such as Boating Adventures Ltd is 22,5% p.a.
REQUIRED:
6.1
Define the weighted average cost of capital (WACC), and briefly explain why a
company would calculate the WACC?
6.2
State with reasons whether or not you agree with the statement made by Mr. Y.A.
Maha concerning the historic cost of capital.
6.3
(3)
(5)
Indicate whether payments on the following instruments are deductible for
taxation purposes:
1) Debentures;
2) Preference shares;
3) Long-term loans;
4) Bank overdraft;
6.4
Calculate the market value of the redeemable debentures.
6.5
Calculate the WACC for Boating Adventures Ltd. Give reasons for ALL your
inclusions/exclusions from the WACC for each balance sheet item.
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(8)
(20)
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MEMO: QUESTION 5
(40 MARKS)
1. WACC is defined as the weighted average cost of capital (1). The WACC is actually a required rate of return or the minimum required return to the
shareholders and other permanent providers of capital (1) to ensure that they are compensated for the risk that they take on by providing finance (1). An
entity needs to calculate the WACC to determine whether the benefits arising from a project exceeds the cost of investing in the project (1) (i.e. used to
evaluate capital investment projects).
2. No, I disagree with the statement made by Mr Y.A. Maha (1). The cost of capital that should be used to evaluate the new project should not be the same
as the cost of capital used to evaluate previous investments. The reasons are:

The new project has a different risk profile than the previous investment/project (1).

When evaluating a new project we assume that we would need new financing (1) and therefore the cost of obtaining financing should be the new
market rates and not historic rates (1).

A possible new capital structure could lead the company to a new cost of capital (1).
3. The following is deductible for taxation purposes:

Interest on debentures; (1)

Interest on long-term loans; (1)

Interest on bank overdraft; (1)
The following is not deductible for taxation purposes:
 Preference share dividends. (1)
4. The effective cost of debentures:
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3. Debentures
(8)
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Ref
Interest
After tax cost of interest
1
2
Payment of instalments
3
31-Mar
2016
-192 500
TOTAL
Cash flow
Present Value
31-Mar
2017
-275 000
-192 500
31-Mar
2018
-275 000
-192 500
-192 500
31-Mar
2019
-275 000
-192 500
-192 500
1
31-Mar
2020
-275 000
-192 500
-192 500
2
31-Mar
2021
-275 000
-192 500
-192 500
3
4
1P for doing a Present Value calculation
Calculation 1
Redeemable Debentures @ book value
Number of debentures
Par value of debentures (bookvalue/0.9%)
Interest @ 11% of par value
2 250 000
20 000
2 500 000
(1)
-275 000
(1)
-192 500
(1)
2 500 000
-1 250 000
(1)
Calculation 2
After tax interest:
Par value interest of
debenture *0.7
Calculation 3
Par value
2 Equal instalments
Calculation 4
Cfj 1
Cfj 2
Cfj 3
Cfj 4
Cfj 5
Cfj 6
I/Yr
NPV
-192 500
-192 500
-192 500
-192 500
-1 442 500
-1 442 500
8.4%
2 484 788.29
(1P)
Including the cash flow
(1P)
Including the cash flow
(1)
(1P)
(12% x 0.7)
Calculating NPV
Max (8)
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31-Mar
2022
-275 000
-192 500
-192 500
4
31-Mar
2023
-275 000
-192 500
31-Mar
2024
-275 000
-192 500
-1 250 000
-1 250 000
-1 442 500
-1 442 500
5
6
(1)
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5. Cost of Capital:
1. Equity
(2)
Market value of Share Capital
=100 000 shares * R 128.50
12 850 000
(1)
Should be included as it forms part on long-term financing
and thus the cost of capital.
(1)
2. Preference Shares
(6)
Non-redeemable, therefore a perpetuity
= 500 000/25 000
20
2.40
Value of pref share
Pref share dividend
(20*.12)
=
Market Value
17.14
=
X
=
Market Value of Pref
share
Cash flow
Required rate of return
2.40
X
14.00%
(1)
(1)
(1P)
Use perp formula
(1P)
For not making after tax
(1)
428 500
Should be included as it forms part on long-term financing
and thus the cost of capital.
(1)
4. Long-term Loan
(10)
The prime interest rate in the current year cannot be used, as we focus on financing that
will be obtained in the future, and therefore in effect the future cost of financing.
(1)
The effective cost of the loan in the market is therefore 15.5% + 2% = 17.5%.
(1)
Should be included as it forms part on long-term financing
and thus the cost of capital.
(1)
Interest 10 years
(1)
After tax cost (*.70)
=3 500 000*.17
595 000
416 500
(1)
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NPV
Cfj 1-9
Cfj 10
416 500
=3 500 000 + 416 500
3 916 500
12.25
I/Yr
(1)
(1)
(1)
(1)
%
(17.5% x 0.7)
3 431 487.38
NPV
(1)
5. Bank overdraft
(2)
The bank overdraft does not form part of the permanent source of financing and therefore
does not form part of the cost of capital.
(1)
(1)
6. Client Loan
(4)
The current loan cannot be used as it does not form part of the permanent source of financing
and therefore does not form part of the cost of capital.
(1)
(1)
The new loan will also not form part of the permanent source of financing and therefore
does not form part of the cost of capital.
(1)
(1)
Cost of Capital
(8)
Item
Market Value
Equity
Preference
Shares
Debentures
1
12 850 000
2
3
428 500
2 484 788
Long-term Loan
Bank Overdraft
Client Loan
4
5
6
3 431 487
-
Cost
22.50
%
14.00
%
8.40%
12.25
%
0.00%
0.00%
19 194 775
Therefore the cost of capital is
18.65
%
Weight
WACC
66.95%
15.06%
(1P)
2.23%
12.95%
0.31%
1.09%
(1P)
(1P)
17.88%
0.00%
0.00%
100.00
%
2.19%
0.00%
-
(1P)
(1P)
(1P)
18.65%
(1P)
(1P)
Not incl
Not incl
Conclusio
n
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Question 6
(13 Marks)
Risky (Pty) Ltd (Risky), a bungy-jumping service provider located in the Drakensberg
mountains, recently got sued for their bungy rope snapping while an individual was doing their
inaugural jump.
After Risky settled the lawsuit, they decided to upgrade their jumping systems. The upgrade
was scheduled to be done in phases over 10 years. Risky wanted to calculate the cost of equity.
They were uncertain what information to use in order to calculate it. They came to the
University of Johannesburg to find a second year student who was proficient in Finance and
could help them with this calculation.
Fortunately, the directors had already done their research and had information that could be
provided by BUNGY Bank Ltd. This is the information that they gave you for their year ended
31 October 2018:
11,00%
Average
over three
months
ended
October
2018
11,50%
10,00%
9,80%
31 October
2018
31 July
2018
31 October
2017
14,0%
16,1%
17,0%
31 October
2018
Interest rates
SA Reserve Bank 91 day treasury
bills
Yield on the most liquid and traded
SA government bond in issue,
redeemable in 2029
Equity markets
20 year average annual return of all
shares listed on the JSE Securities
Exchange
Average of beta coefficients of JSE
listed companies, similar in size and
nature of business to Risky
REQUIRED:
1.20
1.18
1.
Explain the Capital Asset Pricing Model (CAPM) formular in your own words?(4)
2.
Estimate the cost of equity of Risky Ltd at 31 October 2018 based on the information
provided by BUNGY Bank Ltd. Show all workings and provide reasons for using
specific information provided by BUNGY Bank Ltd.
(7)
3.
Why is a government bond considered Risk Free?
Question 7 Suggested Solution
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1.
The Capital Asset Pricing Model is a measure of a companies required rate of return or
cost of equity.  The inputs that are used to derive it are the risk free rate , the asset
beta (or systematic risk)  and return on the market . The risk free rate is added to the
product of the beta and the market premium. The market premium is calculated by
subtracting the risk free rate from the market return. Cost of equity Re = Rf + b (Rm Rf) 
(Max 4)
2.
10%
Risk free rate
• Current yield on government bond redeemable in 2029

provides best proxy
- maturity profile acceptable (10 years = long term/matches new project

timeline)
Beta coefficient
Average beta of similar companies


1.2
acceptable
Adjust the beta for specific risk of company
Return on market
• 20 year average return on JSE at 31 October 2018
Cost of equity derived
Increase cost of equity derived due to higher risks associated with private
14.00%
14.80%
company/↑ beta

(max 7)
3.





A government bond is considered risk free because it has zero or limited default risk.
If the government requires additional funds to settle their debts, they can simply raise
taxes in order to raise the required funds.
(2)
Total: 13 Marks
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Question 7
(47 marks)
Cold Fields Limited is one of the world’s largest unhedged producers of gold with
attributable production of 3,64 million oz per annum from eight operating mines in
South Africa, Ghana and Australia. A ninth mine, Cerro Corona Gold/Copper mine in
Peru, commenced production in August 2008 at an initial rate of approximately
375,000 gold equivalent oz per annum. The company has total attributable ore
reserves of 83 million oz and mineral resources of 251 million oz.
This mining group’s main strategy for the 2009 financial year is to have an aggressive
pursuit of generating strong cash flow as part of their strategy to realize value.
However, as part of Cold Fields’ expansion strategy, they have to complete the
following projects:
A detailed analysis of the financing options available to fund the the above-mentioned
capital projects was performed. The following will be used by Cold Fileds as sources
of finance:
Ordinary shares:
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26,714,158 Ordinary shares were issued by Cold Fields Limited. The dividend is
expected to be R4 per share at the end of the next financial year. Dividend growth is
expected to grow consistently by 10% per year. Shares are currently trading at
R112.31 per share on the Johannesburg stock exchange.
Preference shares:
Cold Fields limited issued R1200m three year non-convertible redeemable preference
shares. The dividend rate payable is a floating rate linked to the prime interest rate
(Hint: use dividend rate of 14%). The entire preference share issue was taken up by
Rand Merchant Bank (RMB) and their opportunity cost associated with this preferance
share issue is 12%.
Project finance facility:
Cold Fields entered into a loan agreement with the Industrial Development Corporation
(IDC) in terms of which the IDC agreed to provide a loan facility of R2660m. Currently
the outstanding debts on this facility is R2300m. Interest will be charged at a fixed rate
of 14% on this facility.
Commercial Bonds:
Cold Fields raised capital in the capital markets by issuing bonds with a principal value
of R1,000m. These bonds have a coupon rate of 15% per annum and coupons will be
paid semi-annually. These bonds will mature in five years. Interest rate outlook is
expected to be stable with Interest rates remaining at 16% per annum.
General:
The effective corporate tax rate is 28%.
REQUIRED:
Part A
1)
Explain in your own words what the Weighted Average Cost of Capital is?(3)
2)
Calculate the Weighted Average Cost of Capital for Cold fields (Round all
amounts to R’millions)
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3)
4)
What are the potential problems with the using Cost of Capital as a basis of
calculation
(4)
Explain the pooling of funds principle on your own words
(4)
Part B
Cold Field have a big strategic focus on generating cash flow at the moment.
Required:
1)
Given the current economic circumstances, please explain why access to cash
is such a major priority for capital intensive corporates at the moment based on
the JP Morgan Cash survey (as discussed in the additional reading material)
(5)
2)
What is your opinion on the current crises in the financial markets
QUESTION 7
(3)
SUGGESTED SOLUTION
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Part A
1) WACC:
The Weighted Average Cost of Capital is the required rate of return given the risk that
they take. .
It reflects the expected average future cost of funds over the long run.

Found by weighting the cost of each specific type of capital by its proportion in the
form’s target / optimal capital structure
Max: 3
2) Calculation of the weighted Average Cost of Capital:
Ordinary Shares:
Gordon Growth Model to determine required return:
Re = (D1÷P0) + g
= (R4 ÷ R112.30) +10%
= 13.56% or 14% rounded
Value of ordinary shares:
26,714,158 Ordinary Shares x R112.30 = R3,000m 
Preference Shares:
Required rate of return:
= 12%

Value of Preference Shares:
PMT = -168 (14% x R1200m)
FV = -1200

I/Y = 12%
P/Y = 1
N
=3

PV = 1257.64

Project Finance facility:
Funding rate
= 14% x (1-0.28)  = 10.08%
Value of loan:
=R2300m

Commercial Bonds:
Funding rate
= 16% x (1-0.28)  = 11.52%
Value of Bonds
P/Y = 2

FV
=-1000

PMT =-75

N
=10

OR
P/Y
FV
PMT
N
=2
= -1000
=(-75x(1-0.28)) -54
= 10
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I/Y
PV


=16%
=996.45
Total Capital:
Ordinary Shares:
Preference Shares:
Project Finance facility:
Commercial Bonds:
Total:
I/Y
PV
=(16%x(1-0.28)) 11.52%
= 973.2
R3,000m
R1,257.64m
R2,300m
R996.45m
R7,554.09m P
WACC
=(3,000 ÷ 7,554.09 x 14%)+ (1,257.64 ÷ 7,554.09 x 12%)+ (2,300 ÷ 7,554.09 x
10.08%)+ (996.45 ÷ 7,554.09 x 11.52%)
=12.15%P
Presentation marks
 if amounts were reflected in Rand millions
 if percentages were not reflected in decimals
3)






Reliance on accounting rather than market information
Properly accounting for inflation (Is it the real interest rate or nominal) 
Fitting real world data into theoretical models
Difficulties in how your discount rate is used
Choosing which measure to use
Properly applying the principals of marginality 
(Available 6, Max 4)
4)
Pooling of Funds Principle



The pooling of funds means that the projects are not financed from one
specific source.  When evaluating projects, we comparing the IRR to WACC based on
the funds pooled.
All projects expected are financed from a joined pool of funds that includes all the
sources in the capital structure. [in their current ratio to prevent suboptimal decision
making]
An average of the pool of the sources of finance needs to be determined in order to get
the most accurate cost of capital 
Part B
1)
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




Risk adversion is the order of the day, due the fact that this has been a tumuluous year in
the money markets 
There is currently a hightened concern over the availability of liquidity in the money
markets 
High profile banks are collapsing or dependant on rescue government packages, causing
Corporates to enter into multiple bank relationships. 
Worldwide corporates are therefore focussed on building their own bank deposits. 
46% of Companies across the globe are expecting to increase their short term borrowing
in the coming year and hence the fear that there may not be money available in the
money markets to fund these debt requirements. 
2)
Principal marks 
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Question 8
(13 marks)
Indicated below is the yield curve for government bonds as at 31 December 2008.
Top line = Oct 08
Middle line = Nov 08
Bottom line = Dec 08
Required:
1)
Describe in your own word what a bond is?
(3)
2)
Describe what yield to maturity is?
(2)
3)
Describe what the yield curve is?
(2)
4)
What does the domestic yield curve tell us and interpret the above Domestic
yield curve as compiled by the Bond Exchange of SA?
QUESTION 8
(6)
SUGGESTED SOLUTION
1) A bond is a long-term debt instrument that pays the bondholder a specified amount of
periodic interest rateover a specified period of time
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2) The bond’s yield-to-maturity is the yield (expressed as a compound rate of return) 
earned on a bond from the time it is acquired until the maturity date of the bond. 
3) A yield curve graphically shows the relationship between the time to maturity  and
yields for debt in a given risk class
4)
a. The Domestic Yield Curve on Government Bonds is compiled from actual
market prices of government bonds as traded on Bond Exchange of South
Africa
b. It reflects the current prices of all the various classes of bonds as issued by the
Government of South Africa based on the maturity of each series of government
bonds issued. 
c. It provides us with a good indication of forecasted market expectations on
interest rate changes as well as the inflationary expectations in the economy

d. It is therefore expected that interest rates will decline in the South African
economy over the long term
e. The interest rate outlook also changed from October 2008 to December 2008
reflecting a much sharper drop in expected interest rates in the future. 
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Question 9
Cost of Capital Adcock Ingram to consume Cipla Medpro
50 Marks
Reuters: – “South Africa's No. 2 drugs producer Adcock Ingram plans to offer R2.1
billion for rival Cipla Medpro South Africa (CMSA) to boost its share of the generic
medicine market.
The cash offer, which values CMSA at about R4.75 per share which is 36% higher than
its closing share price on April 7, pushed the company's stock up to/by about 20%.
Adcock, which was listed on the JSE last August and is the country's second biggest
pharmaceutical firm after Aspen, said it had secured support from four leading CMSA
shareholders holding a combined 30 percent of the company's shares.
No one at CMSA was immediately available to comment.
CMSA, formerly known as Enaleni Pharmaceuticals, is one of South Africa's largest
generic pharmaceutical firms. It has a long-term arrangement to sell products
developed by India's Cipla Limited in South Africa.
The deal would give Adcock, which was spun off from consumer goods firm Tiger
Brands last year, more muscle to compete with Aspen in the fast-growing generic drug
market.
It would also be the latest in a series of similar transactions as traditional
pharmaceutical companies worldwide seek new revenue streams to offset the impact
of patent expiries.
In order to measure the risk profile of the consolidated entity, created by the potential
merger of Cipla & Adcock Ingram, we need to determine the proposed cost of capital
for the new entity.
Below is an extract of the consolidated Statement of Financial Position:
Statement of Financial Position as at 30 June 2019
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Referenc
e
Equity
Share Capital (R1 shares)
Share Premium
1
1
R300 000
R12 650 000
Liabilities
Non-current liabilities
Preference Shares (12%)
Debentures (16.5%)
Long term loan (18% variable)
2
3
4
R1 500 000
R18 700 000
R15 300 000
Current liabilities
Bank Overdraft
Sundry Creditors
5
6
R2 000 000
R950 000
Additional Information
1. Shares are currently trading on the JSE for R37.90 per share.
2. The preference shares consist of 25 000 non-redeemable preference shares.
Similar preference shares currently trade in the market for R55.38 per share.
3. Debentures:
The debentures were issued in denominations of R200.
The market value of these debentures at balance sheet date is R252 inclusive
of interest for 6 months. Interest is payable on 30/06 and 31/12 every year.
The debentures are redeemable in 8 years time
Flotation costs of 5% are payable on all new debentures issued.
4. Long term loan
The bank has given Adcock the option of redeeming the loan on the 01/07/2019
at R14 790 000. The company will however not exercise the option.
5. The bank overdraft will be redeemed in the following month and will not be used
as a source of financing again, due to the high cost of the overdraft facility.
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6. The sundry creditors relate to various short term exposures.
Other information:

The current market value represents the optimal capital structure.

The prime interest rate is currently 14%.

The take-over of Cipla is expected to be fully repaid within 10 years.

Assume a tax rate of 28%.
Adcock Ingram
Number of shares in issue
Current share price
Beta
Effective normal income tax rate
Dividend per share declared on 31 January 2019
15 000 000
R37.90
0.90
28%
75c
Other information
Current yield of the R204 RSA government bond,
maturity date 21 December 2028
Current yield of the R153 RSA government bond,
9,0%
maturity date 31 August 2020
Adcock Ingram premium for market risk
9,4%
8,0%
REQUIRED:
a) Briefly explain what the importance of cost of capital is, as well as the relevance
thereof for companies in general.
(5)
b) Calculate the weighted average cost of capital. Give reasons for ALL your
inclusions/exclusions from the WACC for each balance sheet items.
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(40)
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c) Identify the key procedures that Adcock Ingram should follow in assessing the
creditworthiness of new customers.
(5)
SUGGESTED SOLUTION
a)








The minimum return that a project must offer before it can be accepted. 
It is the return rate that is required by capital suppliers. 
The opportunity cost of investing in that project. 
= Cost of equity + Cost of debt + Cost of preference shares. 
It shows the risk of the company. 
It is the weighted average cost of required returns of providers of long-term or
permanent capital 
Projects with a return of more than WACC should be accepted. 
Pooling of funds
b)
Ordinary shares
(Re)
= Rf + B(Rm - Rf) 
Cost of equity
Risk free rate = R204 bond (long term yield)
Beta co-efficient of Cloth Group given
Insufficient information given in the question to determine whether
the quoted beta is levered or unlevered beta
Market risk premium given
Cost of equity therefore
9.00%
0.90


8.00%
16.20%


P
Market value
R37.90 x 300,000 ordinary shares = R11,370,000
Ordinary shares should be included as part of long term financing and thus cost of capital
(i.e. permanent)
Preference shares
Non-redeemable, therefore a perpetuity
Value of pref share
=1 500 000/25 000
=60 
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7.20
Pref share dividend
(60*.12)
Market Value =
R55.38 
X

Cash flow
__________________
Required rate of return
=
=
7.20 
X
13.00% 
Market Value of Pref shares:
R55.38x 25,000 pref shares = R1,384,500
Preference shares should be included as part of long term financing and thus cost of capital
(i.e. permanent)
Debentures
Effective Cost of debentures
Debentures should be included as part of long term financing and thus cost of capital (i.e.
permanent)
Market value: Need Ex-interest market value
Interest = 200  x 16,5% x 6/12
= 16,5
MV ex-interest = 252 – 16,5
= 235,5 P
Total MV = 235,5 x 93 500 P (if interest was deducted)
= 22 019 250 P
Cost of Debentures: R’000
P/Y
=2
PMT
= -18,700 x 6/12 x 16.5% x 72% Alternatively: -R18,700 x 6/12 x
16.5% = R1,542.75
=-1,110.78
FV
= -18,700
N
= 16 
PV
= 22,019 x 0.95
=20,918.05
I
= ? 9.71%
Alternatively:
PMT = 16.5 
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FV: = 200
PV: = 235.5 x 95%
Long term loan
Long term loans should be included as part of long term financing and thus cost of capital
(i.e. permanent)
Market value: 14 790 000
Cost of long term debt: 18% x 72%= 12.96%
Bank Overdraft
Bank Overdraft does not form part of the long term financing structure of Adcock Ingram 
(i.e. not permanent)
Therefore it should not form part of cost of capital 
Sundry Creditors
Sundry creditors does not form part of the long term financing structure of Adcock Ingram 
(i.e. not permanent)
Therefore it should not form part of cost of capital 
Weighted Average Cost of Capital
Total: 46
Max: 40
(c)
Key procedures should include checking the following:
 The financial position of new customer (proof of salary, personal balance sheet,
ownership of fixed property etc) (capital)
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1
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






Credit history which can be established by independent credit checks with bureaus
Requirements of the National Credit Act & FICA (proof of residency & ID documents)
The amount of credit applied for versus surplus monthly cash flow (Capacity)
Assess the attitude of debtors towards the commitment of honouring debt (character)
Security provided by the debtor (collateral)
Economic Conditions that the customer is trading in
Other valid procedures
Available
Maximum
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1
1
1
1
1
1
1
8
5
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Question 10
40 Marks
Woolworths (Proprietary) Limited is a respected retail chain of stores offering a selected range
of clothing, home ware, food and financial services under its own brand name. During the 2009
financial year, Woolworths completed share buy backs to the value of R1.1 billion. This was
conducted to lower the cost of capital at Woolworths.
The following is an extract of the Statement of Financial position as at 30 June 2009
NOTES
R'm
EQUITY & LIABILITIES
Share capital
Share premium
Treasury shares held
Non-distributable reserve
Distributable reserve
Ordinary Shareholders' equity
1
1.10
141.60
(316.50)
207.20
2,991.40
3,024.80
Preference shares
2
1,376.80
Total Shareholders' interest
4,401.60
Non-current liabilitie s
Interest-bearing borrowings
Operating lease accrual
Deferred tax
3
4
5
2,053.70
1,531.60
456.80
65.30
6
2,372.80
2,372.80
Current liabilitie s
Trade & other payables
Total equity and liabilitie s
8,828.10
Notes:
1) Ordinary Share Capital
Woolworths is listed on the Johannesburg Stock Exchange under share code WHL. As
at 30 June 2009, Woolworths had 775 million ordinary shares in issue. As at 3 February
2010 ordinary shares were trading at a price of R18.00 per share. Because of the
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nature of their products, the share price of Woolworths is typically less volatile than that
of a fully diversified market portfolio, and expects a R0.73 increase in return when the
value of a similar diversified portfolio increases by R1.00. The expected return on a fully
diversified portfolio is currently 15%.
2) Preference Shares
Woolworths issued 1 million non-redeemable preference shares in June 2005. The
dividend rate applicable is a variable rate of prime. Dividends will be declared annually.
These preferences shares are actively traded and the current market value is R1,400
per share. The par value (nominal value) of the preference shares is R1,376.80 per
share.
3) Interest bearing borrowings consist of:
Non-current unsecured loan:
R500 million fixed rate loan. Woolworths entered into this long term loan with ABSA
Capital on 30 June 2009. Woolworths agreed with Absa Capital to structure the
repayment of the loan in the following manner:

Woolworths will obtain a payment holiday until June 2012

Woolworths will then start paying annual installments of R50 million until June 2014

The above-mentioned installments will increase to R100 million until June 2019

The balance will be settled as a final balloon payment of R550 million in June 2020
Dates
Number
of
installments
annual
Value
of
annum
July 2009 to June 2012
3
R0
July 2012 to June 2014
2
R50 million
July 2014 to June 2019
5
R100 million
June 2020
1
R550 million
Secured fixed rate bonds in issue:
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Installment
per
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R1 000 million, 8-year notes maturing on 30 June 2017 with a coupon rate of 12%
compounded semi-annually. These bonds have a par value of R1,000 each and they
are currently trading at a premium of 20%.
Finance Lease
The outstanding liability of the lease is R31.6 million. The group has entered into
finance leases for various items of vehicles and computer equipments. These leases
have terms of renewal between three and five years. Floating rate interest of prime plus
1% will be charged on the leases.
4) Operating leases
The group has entered into various operating lease agreements on premises. The
amount reflected on the statement of financial position, represent lease rentals in
arrears which will be repaid shortly.
5) Deferred Tax
Woolworths has a deferred tax asset of R162 million. It is expected that the deferred
tax liability will be realised through utilizing the current deferred tax asset.
6) Sundry creditors
This amount relates to various short term exposures, which will be settled shortly. The
current sundry creditors are not deemed to be source of permanent financing by
management.
7) Other information:

The current market value represents the optimal capital structure.

The prime interest rate is currently 10.5%.

Assume a tax rate of 28%.

The R186 government long bond is currently trading at a yield of 9.13%

The Statement of Financial Position reflects nominal values.
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Required:
Calculate the weighted average cost of capital. Give reasons for ALL your
inclusions/exclusions from the WACC for each statement of financial position item (40)
Question 10 Suggested Solution
Ordinary Share Capital
Ordinary shares should be included as part of long term financing and thus cost of
capital (i.e. permanent)
Cost of Equity
Ke
= Rf + B(Rm - Rf) 
Risk free rate = R186 bond (long term yield)  9.13%
Beta = 0.73
Market rate on a fully diversified portfolio = 15%
Cost of equity = 13.42% Principle
Market value
R18  x 775 million ordinary shares  = R13 950 million
Share premium, treasury shares and reserves form part of the valuation for equity. 
Preference shares
Preference shares should be included as part of long term financing and thus cost of
capital (i.e. permanent)
Cost of preference shares
Nominal value of a preference share = R1,376.80
Dividend received in a year = 1,376.80 x 10.5% = R144.56 per share
Market value of preference shares = R1,400 per share
Thus, the required rate of return = 144.56/1400 = 10.33%
Market value
R1,400 x 1 million preference shares = R1,400 million
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Interest bearing borrowings
Interest bearing borrowings should be included as part of long term financing and thus
cost of capital (i.e. permanent)
Cost of unsecured loan
Cf0 = R500 million
C01 = 0
F01 = 3
C02 = -R50 million
F02 = 2
C03 = -R100 million
F03 = 5
C04 = -R550 million
F03 = 1
IRR = 9.83% x 72% = 7.08
Market value = R500 million
Fixed Rate bonds
Included in Cost of Capital as it is a long term source of finance. 
Cost of Fixed Rate bonds
N= 16
P/Y = 2
FV = -R1,000 million
PMT = -R60 million  x 72%  (After tax rate)
PV = R1200 million
I/Y = ? = 5.51%
Market value = R1,200 million
Note to marker: If the student worked with cash flows before tax, and converted
the I/Y to an after tax- rate allocate 1 mark
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Finance lease
Included in Cost of Capital as it is a long term source of finance. 
Market value = R31.6 million
Cost of the finance lease = (10.5% +1%) x 72% = 8.28%
Operating lease
Arrears operating lease exposures do not form part of the long term financing structure
of Woolworths (i.e. not permanent) there is also no interest charge associated with
operating leases. 
Therefore it should not form part of cost of capital 
Deferred Tax
Deferred tax will be set-off against deferred tax assets and therefore does not form
part of the long term financing structure of Woolworths
Therefore it should not form part of cost of capital 
Sundry creditors
Sundry creditors does not form part of the long term financing structure of
Woolworths (i.e. not permanent)
Therefore it should not form part of cost of capital 
WACC calculation
Instrument
Ordinary shares
Preference shares
Unsecured Loan
Bonds
Finance lease
R'm
Market value
13 950.0
1 400.0
500.0
1 200.0
31.6
17 082
Percentage
81.67%
8.20%
2.93%
7.03%
0.18%
100.00%
Cost
13.42%
10.33%
7.08%
5.51%
8.28%
Total = 46 Marks
Max = 40 Marks
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WACC
10.96%
0.85%
0.21%
0.39%
0.02%
12.42%






Principle
Principle
Principle
Principle
Principle
Principle
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Question 11
35 Marks
The Sasol Group comprises diversified fuel, chemical and related manufacturing and
marketing operations, complemented by interests in technology development and oil and gas
exploration and production.
Sasol Limited is currently listed on two stock exchanges (JSE and NYSE), and is subject to the
disclosure rules and obligations imposed by these exchanges and their regulators (eg the SEC
in the USA).
As a listed company, Sasol communicates on an ongoing basis with stakeholders (eg. banks,
institutional and retail investors, analysts, equities sales people, fund managers, ratings
agencies etc), to ensure that the stakeholders understand Sasol's strategy, operations,
performance and future prospects.
Sasol's capital providers consist of both equity investors and lenders/debt providers (banks
and Institutional investors lending to Sasol or investing in its issues of debt instruments such
as local bonds, offshore bonds, commercial paper issues, project finance, loans and other
credit facilities and convertible instruments).
Sasol's financial year runs from 1 July to 30 June. The group reports on financial performance
twice annually for interim and annual results.
On 1 December 2009 Sasol approved an investment of R 8,4 billion which will double the
Sasol Wax production of hard wax in South Africa. Sasol Wax would be a new division that
would be started.
"This large investment shows Sasol's commitment to the wax business and enables us to grow
with our customers in this market," says Johan du Preez, managing director of Sasol Wax.
To finance the new wax production for an amount of R8,4 billion, Sasol Wax planned to issue
the following instruments on 1 July 2010:
Shares
The share price of each Sasol Wax was valued at R280. Sasol Wax planned to issue 15 million
shares. In the previous financial year, Sasol declared a dividend of R11.50 per share. Sasol
expects a stable average growth rate for the company of 7%. Marita McKrenzo, a professor in
the department of finance was researching market behaviour and discovered that when the
average market return declined by 15% in the recession, Sasol shares only declined by 8%.
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Her research also showed that the average market risk premium that investors were looking
for was 7%.
Debentures
Sasol planned to issue 90 million debentures with a R24 par value. Each debenture was going
to be issued at R25.20 per debenture. The terms of the debenture were as follows:
Redemption date: 30 June 2018
Redemption value: Premium of 8% to nominal value.
Coupon: 9%
Payment period: Semi-annually on 31 December and 30 June until redemption date
Non-participating Preference Shares
Sasol Wax management were also planning to issue 50 million non-participating preference
shares with a par value of R32 per share as “they said that a preference share allowed for
additional financing without giving away any more ownership or decision-making powers,
however will incentivize shareholders to invest as they will receive any unpaid accumulated
dividend plus capital in case of liquidation,” said Johan Du Preez. The expected dividend for
the preference share was 12% of nominal value. Each preference share is going to be issued
at a price of R36.96. These shares are not redeemable.
Bank Overdraft
Sasol has a bank overdraft facility of R250 million. The current balance of the overdraft is R84
million. This balance has been maintained at this level for over ten years now and
management said that they expect it will be maintained for the next ten years. Due to the size
of Sasol, the Financial Director managed to negotiate an interest rate of prime plus 2 on the
overdraft from the bank. The overdraft has been used in the financing of their assets.
Current Liabilities
The current liabilities balance was R20 million from normal trading. This is expected to be
settled before the year is over.
Additional information

The tax rate is 28%

The prime rate is 10.5%

The R187 is currently trading with a return of 8.7% and is the basis for all Sasol trading.

Sasol regards market values as their optimal capital structure.
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REQUIRED
a)
Explain in your own words what weighted average cost of capital is.
b)
Calculate the Weighted Average Cost of Capital for Sasol Wax division.
(5)
(30)
__________________________________________________________________________
Question 11 Cost of Capital Suggested solution
a)
- The minimum return that a project must offer before it can be accepted. 
- It is the return rate that is required by capital suppliers. 
- The opportunity cost of investing in that project. 
- = Cost of equity + Cost of debt + Cost of preference shares. 
- It shows the risk of the company. 
- It is the weighted average cost of required returns of providers of long-term or
permanent capital 
Available (6)
Max (5)
b)
Weighted Average Cost of Capital
Shares - Cost of Equity
Re
= Rf + b(Market premium)
= 8.7%  + 8%/15%  (7%) 
= 12.43%
Re
= (D1  MV) + g
= [(11.50  x 1.07)/ 280] + 0.07
= 11.40%
Therefore Average Re = (12.43% + 11.40%) / 2 = 11.91%P
MV
= Number of shares x Price
= 280 x 15 million shares  = 4,2 billion
Debentures
P/yr = 2 
PV = -25.20 
FV = (24 x 1.08) = 25.92 
PMT = (9% x 24)/2 x 72% = 0.778
N = 8 x 2 = 16 
Therefore I/Yr = 6.45% 
MV
= Number of shares x Price
= 25.20 x 90 million  = 2.268 billion
Non – Participating Prefs
Rp
= Div / MV
= (0.12 x 32) / 36.96 
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= 10.39% 
MV
= Number of shares x Price
= 36.96 x 50 million  = 1,848
Bank Overdraft
Rd
= Prime + 2
= 10.5% + 2 
= 12.5% x 72%
= 9%
MV
= R84 million 
Shares
Debentures
Non-Participating
Prefs
Bank Overdraft
Total
MV
4,20
0
2,26
8
1,84
8
8
4
8,40
0
Ratio
Cost
WACC
50%
11.91%
5.96%
P
27%
6.45%
1.74%
P
22%
10%
2.29%
P
1%
9%
0.09%
P
10.08%
P
100%
Attention to marker: give the principle mark for each line if the logic of it makes sense
Available (34)
Max (30)
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