Question 6

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Question 6 Calculation of specific costs, WACC,
and WMCC. Dillon Labs has asked its financial
manager to measure the cost of each specific type
of capital as well as the weighted average cost
of capital. The weighted average cost is to be
measured by using the following weights 40
percent long-term debt, 10 percent preferred
stock, and 50 percent common stock equity
(retained earnings, new common stock, or both).
The firm's tax rate is 40 percent. Debt. The firm
can sell for R980 a 10-year, R1 000-par-value
bond paying annual interest at a 10 percent
coupon rate. A flotation cost of 3 percent of the
par value is required in addition to the discount
of R20 per bond. Preferred stock/preference
shares. Eight- percent (annual dividend)
preferred stock having a par value of R100 can be
sold for R65. An additional fee of R2 per share
must be paid to the underwriters. Common
stock/ordinary shares. The firm's common stock is
currently selling for R50 per share. The dividend
expected to be paid at the end of the coming year
(2006) is R4. Its dividend payments, which have
been approximately 60 percent of earnings per
share in each of the past 5 years, were as shown
in the following table.

• It is expected that, to sell, new common stock
  must be underpriced R5 per share and the firm
  must also pay R3 per share in flotation costs.
  Dividend payments are expected to continue at 60
  percent of earnings.
• Calculate the specific cost of each source of
  financing.
• If earnings available to common shareholders are
  expected to be
• R7 million, what is the breaking point associated
  with the exhaustion of retained earnings?
• c. Determine the weighted average cost of capital
  between zero and the breaking point calculated in
  b.
• d. Determine the weighted average cost of capital
  just beyond the breaking point calculated in b.

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COST OF CAPITAL WACC
Question 6

PV
DEBT Kd I M Bo n
M Bo 2
PMT
FV
n
?
i
.. ..
.
.

• .
• Ki Kd (1-T)
• ..

PREFERENCE SHARES Kp Dp Np
. . .
3
ORDINARY SHARES
GORDON GROWTH CAPM MODEL Ks Rf b
x (Km Rf)

• Ks D1 g
• P0
• Ks D1 g
• P0
• New Ordinary Shares
• Kn D1 g
• Nn

Growth on Div 01 02 03 04
05
PV
FV
n
i
4
WACC R0 - R5 600 000
ABOVE R5 600 000
5

• Question 7
• Calculation of specific costs, WACC, and WMCC.
  Lang Enterprises is interested in measuring its
  overall cost of capital. Current investigation
  has gathered the following data. The firm is in
  the 40 percent tax bracket.
• Debt. The firm can raise an unlimited amount of
  debt by selling R1 000 par value, 8 percent
  coupon interest rate, 20 year bonds on which
  annual interest payments will be made. To sell
  the issue, an average discount of R30 per bond
  would have to be given. The firm also must pay
  flotation costs of R30 per bond.
• Preferred Stock//preference shares. The firm can
  sell 8 percent preferred stock at itsR95 per
  share par value. The cost of issuing and selling
  the preferred stock is expected to be R5 per
  share. An unlimited amount of preferred stock can
  be sold under these terms.
• Common Stock/ordinary shares. The firm's common
  stock is currently selling for R90 per share. The
  firm expects to pay cash dividends of R7 per
  share next year. The firm's dividends have been
  growing at an annual rate of 6 percent, and this
  is expected to continue into the future. The
  stock must be underpriced by R7 per share, and
  flotation costs are expected to amount to R5 per
  share. The firm can sell an unlimited amount of
  new common stock under these terms.
• Retained earnings. When measuring this cost, the
  firm does not concern itself with the tax bracket
  or brokerage fees of owners. It expects to have
  available R100 000 of retained earnings in the
  coming year once these retained earnings are
  exhausted, the firm will use new common stock as
  the form of common stock equity financing.
• Calculate the specific cost of each source of
  financing. (Round answers to the nearest .1
  percent).
• The firm's capital structure weights used in
  calculating its weighted average cost of capital
  are shown in the following table. (Round answer
  to the nearest .1 percent).

• Calculate the single breaking point associated
  with the form's financial situation. (Hint This
  point results from exhaustion of the firm's
  retained earnings.)
• Calculate the weighted average cost of capital
  associated with total new financing below the
  breaking point calculated in (1).
• Calculate the weighted average cost of capital
  associated with total new financing above the
  breaking point calculated in (1).

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COST OF CAPITAL WACC
Question 7

___? ___ ____ ____
DEBT Kd I M Bo n
M Bo 2
?
___ ____-____
.. _____ ___
.
____

• _______
• Ki Kd (1-T)
• ______ (__-_____)
• _______

PREFERENCE SHARES Kp Dp Np
R______ R. _______
7
ORDINARY SHARES
GORDON GROWTH CAPM MODEL Ks Rf b
x (Km Rf)

• Ks D1 g
• P0
• Ks D1 g
• P0
• R___ ______
• R___
• ________
• _______
• New Ordinary Shares
• Kn D1 g
• Nn
• R___ ______
• R___
• ________

8
WACC R0 R200 000
ABOVE R200 000
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Question 8 Integrative WACC, WMCC, and IOS.
Cartwell products has compiled the data shown in
the following table for the current costs of its
three basic sources of capital long-term debt,
preferred stock and common stock equity for
various ranges of new financing.
The company's capital structure weights used in
calculating its weighted average cost of capital
are shown in the following table.
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Question 8 Contd.

• Determine the breaking points and ranges of total
  new financing associates with each source of
  capital
• Using the data developed in a, determine the
  breaking points (levels of total new financing)
  at which the firm's weighted average cost of
  capital will change.
• Calculate the weighted average cost of capital
  for each range of total new financing found in b.
  (Hint There are three ranges.)
• Using the results of c along with the following
  information on the available investment
  opportunities, draw the firm's weighted marginal
  cost of capital (WMCC) schedule and investment
  opportunities schedule (IOS) on the sale set of
  total new financing or investment (x axis)
  weighted average cost of capital and IRR (y axis)
  axes.
• Investment Internal rate Initial
• opportunity of return (IRR) investment
• A 19 200 000
• B 15 300 000
• C 22 100 000
• D 14 600 000
• E 23 200 000
• F 13 100 000

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Project R500 000
Question 8
PREF
DEBT .. ..
ORD
Bp ORDINARY SHARES Bp Af W
. .
DEBT Bp . .. .
R0-500 000
R500 000 R800 000
12
ABOVE R800 000

0
R
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CAPM

• Ks Rf b x (Km Rf)
• TWO LESSONS OF INVESTMENT
• WHEN INVESTING, YOU MUST ALWAYS SEEK A RISK
  PREMIUM.
• DONT FORGET, ALL RETURNS ARE VARIABLE.
• RISK PREMIUM
• YOU CAN INVEST IN A GOVERNMENT BOND RISK FREE.
• WHY WOULD YOU INVEST IN ANYTHING OTHER THAN A
  GOVERNMENT BOND?
• BECAUSE YOU HAVE THE POTENTIAL TO EARN A HIGHER
  RETURN.
• HENCE, WE SAY THAT YOU MUST ALWAYS SEEK A RISK
  PREMIUM.

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RISK PREMIUM

• (Km Rf) GENERAL
• MARKET RISK PREMIUM.
• THEORETICALLY, THIS WILL BE POSITIVE.
• SO, HOW DO WE FACTOR IN THE RISK PREMIUM THAT THE
  SPECIFIC ASSET ADDS TO THE EQUATION?

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BETA

• THERE ARE TWO TYPES OF RISK THAT WE ARE
  INTERESTED IN?
• SYSTEMATIC OR NON-DIVERSIFIABLE RISK THIS IS A
  RISK THAT THE WHOLE ECONOMY IS EXPOSED TO, SUCH
  AS INFLATION, POLITICAL INSTABILITY, EXCHANGE
  RATES AND SO ON.
• UNSYSTEMATIC OR DIVERSIFIABLE RISK THIS IS A
  RISK THAT A PARTICULAR INDUSTRY OR BUSINESS IS
  EXPOSED TO, SUCH AS PROBLEMS WITH A SUPPLIER,
  LABOUR PROBLEMS AND SO ON.

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BETA

• SEEING AS WE CAN DO SOMETHING ABOUT DIVERSIFIABLE
  RISK, WE DO NOT WORRY ABOUT IT.
• OUR CONCERN IS ABOUT THE NON-DIVERSIFIABLE OR
  SYSTEMATIC RISK.
• HOW DO WE MEASURE THIS RISK?
• RIGHT! THROUGH THE BETA.
• YOU MEASURE THE RETURN ON THE MARKET VERSUS THE
  RETURN ON THE SHARE PRICE.
• YOU WILL LAND UP WITH A SCATTER DIAGRAM AS A
  RESULT.
• THE SLOPE OF THE LINE OF BEST FIT IS THE BETA.

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CAPM Model Ks Rf b x (Km Rf)
___________________
________________
_____________________
__________________
________
_____
____
___
_____
0
____________
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BETA

• SO, WHAT DOES THE BETA MEAN?
• A BETA OF 1 MEANS THAT IF THE MARKET GOES UP BY,
  SAY 10, THEN WE EXPECT THE SHARE PRICE TO GO UP
  BY 10.
• BY THE SAME TOKEN, IF THE MARKET DECLINED BY 10,
  THEN WE WOULD EXPECT THE SHARE PRICE TO DECLINE
  BY 10 AS WELL.
• THEREFORE, A BETA OF 2 MEANS THAT IF THE MARKET
  GOES UP BY 10, THEN WE EXPECT THE SHARE PRICE TO
  GO UP BY 20.