TUTORIAL WEEK 9
1.
Why do we use market interest rates instead of historical interest rates in
calculating a firm’s cost of debt? Why do we prefer to use market values instead
of book values?
2.
GJF, Review Question 11-2 (p. 478)
“Why do we assume business and financial risk are unchanged when evaluating
the cost of capital? Discuss the implications of these assumptions on the
acceptance and financing of new projects.”
3.
GJF, Review Question 11-5 (p. 481)
“What is meant by the net proceeds from the sale of a bond? What are flotation
costs, and how do they affect a bond’s net proceeds”
4.
In January 2013, the CFM Corporation considered a project (project A)
requiring an initial investment of $200,000 and subsequently yielding annual
after tax relevant incremental cash flows of $30,000 for 10 years. At that time
the firm’s after-tax cost of new debt was 8% per annum, its cost of new equity
was 13% per annum, and the firm could only borrow a maximum of $200,000. A
year later in January 2014, CFM had the opportunity of investment in another
(independent) project (project B), which required an initial investment of
$200,000 and was expected to yield annual after tax relevant incremental cash
flows of $36,000 for 10 years.
(a)
If the firm had simply used the cost of the lowest cost form of financing to
calculate the net present value of project A in January 2013, what would
have been this calculated NPV?
(b)
Suppose that based on the result of part (a) above CFM Corporation
undertook project A in January 2013 using only debt financing to raise
the capital to cover the initial investment. As this exhausted the firm’s
debt raising capabilities, it evaluated the NPV of project B a year later
using its cost of equity, which for simplicity we will assume was
unchanged at 13% per annum. Under these assumptions, and supposing
the firm based its investment decision purely on the NPV criterion, would
the firm have invested in project B? Show your reasoning.
(c)
If the firm had instead used a weighted average cost of capital based on
target weights of 50% debt and 50% equity in its calculations, what
decisions would it have taken with respect to investment in projects A and
B? Show calculations to support your answer.
(d)
What conclusion can you draw regarding the desirability of basing
individual current capital budgeting decisions on the cost of the currently
lowest cost source of financing?
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5.
GJF, Problem 11-27 (p. 508)
“After careful analysis, Dexter Brothers Ltd has determined that its optimal
capital structure is composed of the following sources and target market value
weights:
Source of Capital
Long-term debt
Preference share capital
Ordinary share equity
Total
Target Market Value Weight
30%
15%
55%
100%
The cost of debt is estimated to be 7.2%, the cost of preference share capital is
estimated to be 13.5%, the cost of retained earnings is estimated to be 16%, and
the cost of new ordinary share equity is estimated to be 16%. All these are aftertax rates. Currently, the company’s debt represents 25%, the preference share
capital represents 10%, and the ordinary share equity represents 65% of the
total capital based on the market values of the three components. The company
expects to have a significant amount of retained earnings available and does not
expect to sell any new ordinary share equity.
(a)
(b)
(c)
6.
Calculate the WACC based on historic market value weights.
Calculate the WACC based on target market value weights.
Compare the answers obtained in parts (a) and (b). Explain the
differences.”
The Dr Phil Media Corporation faces an effective company income tax rate of
30%. The firm is financed with debt, preference capital and ordinary equity, for
which the following details are available:
Debt: The firm has 5,000 corporate bonds on issue, each with a face value of
$1,000 and a maturity date in 5 years’ time. The bonds pay interest annually
with a coupon rate of 7.5% per annum, and the current yield to maturity is 8%
per annum.
Preference Capital: There are 100,000 preference shares on issue that have a $10
per share par value and pay annual preference dividends of 8% (of par value).
The current preference share price is $8.
Ordinary Capital: 400,000 ordinary shares are on issue. The current ordinary
share price is $6 per share. The equity beta for these ordinary shares is 1.1, the
expected return on the market portfolio is 7% per annum, and the risk free rate
of interest is currently 4% per annum.
Given the above information, and assuming the capital asset pricing model is
valid, calculate the current weighted average cost of capital for the Dr. Phil
Media Corporation.
(Round your final answer to the nearest 0.01 per cent)
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Additional practice questions - will not be discussed in the tutorial:
1.
In lectures it was stated that if the undertaking of a project is not to change the
financial risk faced by a firm’s ordinary shareholders then normally the
financing of the project should be such that it does not change the capital
structure of the firm. If this condition is to be satisfied, does it mean that a new
project undertaken by a firm that is 50% debt/50% equity financed must
necessarily be financed by 50% debt/50% equity? Explain your answer.
2.
Suppose a firm currently has a WACC of 9% p.a. and that it is considering
investing in a small project. This project is considered to have similar risk
characteristics to financial securities in the capital market for which a 12% p.a.
return is required, however due to the small size of the project it will not change
the firm’s WACC if it is undertaken: in other words investors are willing to
provide the firm with additional capital that could be used to finance the project
at an overall required return of 9% p.a. Using the firm’s WACC of 9% to
discount the cash flows, the NPV of the project is positive whilst if a 12%
discount rate is used the NPV is negative. Should the firm undertake the
project? Explain your answer.
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