Additional Problems
to accompany
Introducing
Corporate Finance
Prepared by
Michelle Goyan
John Wiley & Sons Australia, Ltd
CHAPTER 6 – MANAGED FUNDS
PROBLEM 1
Currently, Agapanthus Industries Ltd can sell 10-year, $100 face value bonds with a
12% pa coupon, paid semi-annually. The bonds can be sold for $105 each. Flotation
costs of $2.50 per bond will be charged by the underwriter handling the issue. The
corporate tax rate is 30 per cent.
a) Find the net proceeds from the sale of the bond.
b) Use the approximation formula to estimate the before- and after-tax cost of debt.
PROBLEM 2
The equity risk premium is expected to be 4.5%. Use the CAPM to estimate the cost
of equity for a Croesus Ltd with a beta of 1.79 if the risk free rate is:
a) 4.3%
b) 6.7%
c) Are the costs you have calculated before- or after-tax costs? Explain.
PROBLEM 3
Monty Ltd’s ordinary shares are currently selling for $9.60. The firm pays annual
dividends and expects the next one to be $0.97. After flotation costs, the firm expects
to net $9.27 per share on a new issue. Dividends are expected to grow at 1.25% for
the foreseeable future.
a) Determine the before- and after-tax cost of retained earnings.
b) Determine the before-and after-tax cost of a new issue.
PROBLEM 4
Given a 30% corporate tax rate and the following information for Pitosporum Ltd:

10 000 bonds with a face value of $100, a coupon rate of 12 per cent , an
issue price of $92.30, and 5 years to maturity. Coupons are paid semiannually. Use the approximate cost of debt method.

70 000 11 per cent preference shares with a face value of $2 and net
proceeds of $1.86.

500 000 ordinary shares with an issue price of $3.00, dividend growth rate 1
per cent per annum in perpetuity. The last dividend was $0.15 and the next
dividend is due in about 1 year. Flotation costs will be 3.5% of the issue price.
a)
Calculate the cost of each source of finance if the marginal investor is an
Australian resident who can fully-utilise imputation credits. Using the weightings
associated with issuing the proposed amount of each security, calculate the
weighted average cost of capital.
b)
Calculate the cost of each source of finance if the marginal investor is an
overseas resident. Using the weightings associated with issuing the proposed
amount of each security, calculate the weighted average cost of capital.
PROBLEM 5
Hydromat Ltd is interested in calculating its weighted average cost of capital and has
presented you with the following data:

$600 000 can be borrowed from the bank for a term of 10 years. The bank will
charge Hydromat an annual effective rate of 13% pa.

Preference shares have a market price of $8 and pay an annual dividend per
share of $0.75. Flotation costs will be 3.9% of the issue price of $7.90.

The firm has $500 000 of retained earnings available for investments.

Hydromat’s ordinary shares have a market value of $7.50 per share. The next
dividend is expected to be $0.75. The current growth rate of 0.5% is expected to
continue indefinitely. Flotation costs will be 2.8% for shares issued at $7.25 each.

The corporate tax rate is 30 per cent.

The target capital structure is as follows:
Source
Long-term debt
Preference shares
Ordinary shares
Weight
40 per cent
20 per cent
40 per cent
a)
Calculate the before- and after-tax WACC assuming no new ordinary shares
will be issued.
b)
Calculate the before- and after-tax WACC assuming no retained earnings are
available for investing in new projects.
PROBLEM 6
Hotcakes Ltd is the Australian subsidiary of a large French company. Most of the
shareholders are overseas residents who cannot utilise imputation credits. The
company has identified the following projects as potential investments:
Project
I
II
III
IV
V
VI
Cost
$3 000 000
$4 000 000
$4 750 000
$2 900 000
$1 950 000
$3 500 000
IRR (a.t.)
10%
13%
11%
15%
16%
9%
The firm’s current capital structure (as well as its targeted future capital structure)
consists of 40 per cent long-term debt, 5 per cent preference shares and 55 per cent
ordinary shares. The following data has been gathered in relation to each of these
sources of finance:

Hotcakes can raise $5 million in long-term debt at a before-tax cost of 15 per
cent.

Preference shares can be sold at an after-tax cost of 10 per cent.

Hotcakes do not expect to have any retained earnings available for new
investments in the coming year. The last annual dividend of $3.50 per share was
paid recently. A new issue would be priced at $27, with flotation costs of $0.75
per share. The average dividend growth rate in recent years has been 1.5 per
cent per annum and this growth rate is expected to continue for the foreseeable
future.

The corporate tax rate is 30 per cent.
a)
Calculate the cost of capital for Hotcakes Ltd.
b)
Recommend which projects Hotcakes should accept.
c)
Given that these are the only projects available for investment, identify the
appropriate size of Hotcakes’ capital budget for this planning cycle
PROBLEM 7
In your position of CFO at Fantasy Fabrics Ltd, it is your job to recommend which
investments the company should make. The investment alternatives are listed below.
Investment
Cutting machine
Computer system
Premises
upgrade
Automated loom
Bleaching vats
Initial outlay
$
120 000
50 000
750 000
345 000
80 000
IRR
(before tax) %
9
8.5
11
IRR
(after tax) %
8
7
10
16.5
15
15
13
Fantasy Fabrics’ current capital structure consists of the following.
Source of finance
Debt
Preference shares
Ordinary equity (including
retained earnings)
Amount of finance
900 000
525 000
900 000
The Board have specified this pattern of funding as the target capital mix.
To raise additional debt, Fantasy Fabrics would issue bonds with a face value of
$1000. The coupon rate on the bonds would be 4% and interest would be paid
annually. The bonds would mature in ten years’ time. Issue costs are 1.5 per cent of
the face value. Use the approximate cost of debt equation to calculate the cost of
debt.
A new offering of preference shares would have issue costs of 3.5%. The preference
shares are trading at $4.50 and new shares would be issued at this price. Fantasy
Fabrics pays fully franked dividends of 42 cents per share.
The ordinary shares have a market price of $6. The next dividend (45 cents, fully
franked) will be paid at the end of the year. Dividends are expected to grow at an
annual rate of 5 percent thereafter. Flotation costs for ordinary shares would be 5%
of the issue proceeds of $5.80 per share. However, Fantasy Fabrics has sufficient
cash to fund the equity portion for all of the proposed projects. Therefore, no new
issue of ordinary shares is to occur.
The corporate tax rate is 30%.
a)
Calculate the cost of capital if Fantasy’s shareholders can fully utilise imputation
credits. Recommend which projects should be accepted.
b)
Calculate the cost of capital if the marginal shareholders are foreign residents.
Recommend which projects should be accepted.
c)
Would your recommendations change if Fantasy Fabrics did not have any cash
that could be used to fund the equity portion of the proposed projects?
Calculate the after-tax cost of capital to demonstrate.