Topic 6 Tutorial Answers

ACC00152 Business Finance Topic 6 Tutorial Answers

1. Problem 7, page 391 of the textbook.

Using the Capital Asset Pricing Model, Steady’s cost of equity capital is:

6% + 0.20 x 7% = 7.4%.

2. Humble Manufacturing is interested in measuring its overall cost of capital. Current investigation has gathered the following data. The firm’s tax rate is 30 per cent. The target capital structure is 40% debt, 15% preference capital and 45% ordinary equity.

Debt:

The firm can raise an unlimited amount of debt by selling 10 per cent, 10-year bonds on which annual interest payments will be made. Bonds would be sold at par.

Preference capital:

The firm’s publicly traded preference shares pay a dividend of 11 per cent of their $10 par value. The preference shares are currently trading for $11.

Ordinary equity:

The firm’s ordinary equity is currently selling for $8.00 per share. The firm expects to pay cash dividends of $0.60 per share in the coming year. The firm’s dividends have been growing at an annual rate of 6 per cent, and this rate is expected to continue in the future.

(a) Calculate the cost of each source of financing.

Cost of debt:

The debt yield will be the same as the coupon at issue if the bonds sell at par value. So, there is no need to calculate the yield to maturity in this question. The before-tax cost of debt is 10%. The after-tax cost of debt is 10%(1 – 0.3) = 7%. The after-tax cost of debt needs to be calculated because interest is tax-deductible, reducing the cost of debt.

Cost of Preference Shares:

Dividend = 0.11 x par value = 0.11 x $10 = $1.10

rP = Div/P0 = $1.10/11 = 10%

Cost of Ordinary Equity:

No beta provided so we can’t use SML approach.

We have all the information needed for the dividend growth model approach:

rE = Div1/P0 + g = $0.60/$8 + 0.06 = 0.075 + 0.06 = 0.135 = 13.5%

(b) Calculate the firm’s WACC.

rWACC = rE E% + rP P% + rD (1 – TC)D%

= 0.135 x 45% + 0.10 x 15% + 0.10(1 – 0.3)40%

=...