# 5.4 Learning Guide Questions 2019

```Department of Accounting, Economics and Finance
Learning Guide
Cost of Capital
2019
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 &amp; EXAM POSSIBILITIES
Cost of capital is a basis for many other topics such capital budgeting to be done in 3rd
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 8th 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)
Section E: TUTORIAL QUESTIONS
The tutorial question that needs to be done for the tutorial is named TUTORIAL
QUESTION MARCH 2018
Section F: ASSIGNMENTS
The Cost of capital assignment is to be discussed with the lecture
Section F: PRE-CLASS PREPARATION
Section G: 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.
ESSAY QUESTIONS
QUESTION 1:
PART A:
Lucky Jackson is trying to choose between the following investment alternatives
recommended to him by his broker:

15% R1 000 bonds of Star Mining Company, selling in the market at R1 146,58.
Interest is payable semi-annually, and the bonds are redeemable in sixteen
years’ time; or

11,75% non-redeemable R100 preference shares of Supernova Minerals
Company, selling in the market at R98.
YOU ARE REQUIRED TO:
advise Lucky as to which investment alternative to choose, by calculating the specific
returns he will earn on the two investments.
QUESTION 2 Assessment 2 2006
[15 marks]
This question consists of TWO independent parts.
PART A
Cresta Investment Ltd is a prospering investment company. They currently (thus year 0)
pay a dividend of R3,50 per annum. They expect their dividends to increase by 8% over
the next 4 years after which it will remain constant.
REQUIRED
2.1
Determine the value of a Cresta-share if an investor requires a return of 16% and
the shares are currently trading cum-dividend.
(9)
PART B
A bond is a form of a fixed interest debt security.
REQUIRED
2.2
Explain the following concepts:
a)
Bond stripping
b)
Floating-rate bonds
c)
Securitised bonds
(3 x 2 = 6)
QUESTION 3 Assessment 2 2007
[30 marks]
This question consists of TWO independent parts
PART A
(12 marks)
The following is an extract from the Balance Sheet of Leeds Limited for the year ended
31 December 2006:
LEEDS LIMITED
EXTRACT FROM THE BALANCE SHEET AS AT 31 DECEMBER 2006
EQUITY AND LIABILITIES
Non-current liabilities
12% Cumulative redeemable preference shares
8.4% R1 000 bonds
Convertible debentures
R
[Note 1]
[Note 2]
[Note 3]
200 000
100 000
500 000
1. Leeds Ltd issued R1 000 cumulative redeemable 12% pref. shares. Although
preference dividends are outstanding for the last 3 years, normal dividend payments
continued from this year. The shares will be redeemed in 4 years time at a premium
of 10%. All outstanding dividends will be paid at that stage. The shares have a
current
value
of
R1 300 each.
2. The bonds issued are 12-year bonds and were issued two years ago at a discount of
5%. The bonds make semi-annual payments. The bonds currently sell for R975.
3. The debentures are convertible to 16 000 ordinary shares in two years time. The
expected value of the ordinary shares in two years time according to Gordon’s
growth model is R30 per share. If the debenture holders do not convert their
debentures it will be redeemed at a discount of 10%. Similar debentures are trading
at 18%.
REQUIRED:
3.1
Calculate the cost of preference shares.
(4)
3.2
Calculate the bond yield-to-maturity
(4)
3.3
Determine whether the convertible debentures will be converted in two year time.
(4)
PART B
(18 marks)
Freeway Limited has two different bonds currently outstanding. Bond A has a nominal
value of R20 000 and matures in 20 years. The bond makes no payments for the first
six years, then pays R1 000 semi-annually over the subsequent eight years, and finally
pays R1 750 semi-annually over the last six years. Bond B also has a nominal value of
R20 000 and a maturity of 20 years; it makes no coupon payments over the life of the
bond. The required return on both these bonds is 12 percent compounded semiannually.
REQUIRED:
3.4
Calculate the current price of Bond A.
(14)
3.5
Calculate the current price of Bond B.
(4)
QUESTION 4:
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 5:
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.
(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 6:
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.
QUESTION 7 (Second Assessment 2008)
(40 MARKS)
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: &quot;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!&quot;
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
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
Bank overdraft
3 651
1 765
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 &quot;pooling of funds&quot; 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
(2)
(4)
QUESTION 8 – June 2008 Assessment
(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 2008:
Balance Sheet
Reference
R
Equity
Share Capital (R2 shares)
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
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 2006. 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 2013 and 2014.
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%.

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:
2.1
Define the weighted average cost of capital (WACC), and briefly explain why a
company would calculate the WACC?
2.2
State with reasons whether or not you agree with the statement made by Mr.
Y.A. Maha concerning the historic cost of capital.
2.3
(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;
2.4
Calculate the market value of the redeemable debentures.
2.5
Calculate the WACC for Boating Adventures Ltd. Give reasons for ALL your
inclusions/exclusions from the WACC for each balance sheet item.
(4)
(8)
(20)
Question 9 (Assessment 1 – 2009)
(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.
provided by BUNGY Bank Ltd. This is the information that they gave you for their year ended
31 October 2008:
Interest rates
SA Reserve Bank 91 day treasury
bills
Yield on the most liquid and traded
SA government bond in issue,
redeemable in 2019
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
11,00%
Average
over three
months
ended
October
2008
11,50%
10,00%
9,80%
31 October
2008
31 July
2008
31 October
2007
14,0%
16,1%
17,0%
31 October
2008
1.20
1.18
REQUIRED:
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 2008 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?
(2)
Question 10 (Assessment 2 – 2009)
(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:
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)
3)
4)
(28)
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)
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
(3)
Question 11 (Assessment 2 – 2009)
(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?
(6)
Question 12: June 2009 assessment
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 &amp; 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 2009
Reference
Equity
Share Capital (R1 shares)
1
R300 000
1
R12 650 000
Preference Shares (12%)
2
R1 500 000
Debentures (16.5%)
3
R18 700 000
Long term loan (18% variable)
4
R15 300 000
Bank Overdraft
5
R2 000 000
Sundry Creditors
6
R950 000
Liabilities
Non-current liabilities
Current liabilities
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 01/07/2009
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.
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%.
Number of shares in issue
Current share price
15 000 000
R37.90
Beta
0.90
Effective normal income tax rate
28%
Dividend per share declared on 31 January 2009
75c
Other information
Current yield of the R204 RSA government bond,
maturity date 21 December 2018
9,0%
Current yield of the R153 RSA government bond,
maturity date 31 August 2010
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.
(40)
c) Identify the key procedures that Adcock Ingram should follow in assessing the
creditworthiness of new customers.
Question 13 (Assessment 2 2010)
(5)
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 &amp; LIABILITIES
Share capital
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
Non-current liabilities
Interest-bearing borrowings
Operating lease accrual
Deferred tax
Current liabilities
Total equity and liabilities
4,401.60
3
4
5
2,053.70
1,531.60
456.80
65.30
6
2,372.80
2,372.80
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 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
annual Value
installments
of
Installment
per
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:
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
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.
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 14 (June Assessment 2010)
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.
&quot;This large investment shows Sasol's commitment to the wax business and enables us to grow
with our customers in this market,&quot; 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%. 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.

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.
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)
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