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COST OF Capital Exercises
Advanced Financial Management (BWFF2043)
Universiti Utara Malaysia
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COST OF CAPITAL
QUESTION 1
Rellphone Company Sdn Bhd. faces increasing needs for capital. Fortunately, it has an Aa credit rating. The corporate tax rate is 36%. Rellphone’s treasurer is trying to determine the corporation’s current weighted average cost of capital in order to assess the profitability of capital budgeting projects. Historically the corporation’s earnings and dividends per share have increased at about a 6% annual rate.
Rellphone’s common stock is selling at RM60 per share and the company will pay at RM4. per share dividend. The company’s RM100 preferred stock has been yielding 9% in the current market. Flotation costs for the company has been estimated by its investment banker to be RM1 for preferred stock. The company’s optimum capital structure is 40% debt, 10% preferred stock and 50% common equity in the form of retained earnings. Refer to the table below on bond issues for comparative yields on bonds of equal risk to Rellphone.
Data on bond issues Issue Ram’s rating Price Yield to Maturity
Utilities: Bakar G&E 2006...................... Aa1 RM975 8% Chempa Tel. Com Sdn Bhd.......... Aa2 RM850 9% Teong Cellular Sdn Bhd.............. A1 RM 960 9%
Industrial: General Mill........................ Aaa RM1,050 8% May Department .................. Aa3 RM 940 11% ICM ................................. A2 RM1,030 9%
Compute:
a. Cost of debt. b. Cost of preferred stock. c. Cost of common equity. d. Weighted Average Cost of Capital (WACC).
QUESTION 2
A firm has determined its optimal capital structure, which is composed of the following sources and target market value proportions:
Source of capital Target market proportions Long term debt 30% Preferred stock 5% Common stock equity 65%
Debt: The firm can sell a 20 year, RM1,000 par value, 9% bond for RM980. A flotation cost of 2% of the face value would be required in addition to the discount of RM20.
Preferred stock: The firm has determined it can issue preferred stock at RM65 per share par value. The stock will pay an RM8 annual dividend. The cost of issuing and selling the stock is RM3 per share.
Common stock: The firm’s common stock is currently selling for RM40 per share. The dividend expected to be paid at the end of the coming year is RM5. Its dividend payments have been growing at a constant rate for the last five years. Five years ago the dividend was RM3. It is expected to sell , a new common stock issue must be underpriced at RM1 per share and the firm must pay RM1 per share in flotation costs. Additionally, the firm’s marginal tax rate is 40%.
Calculate the firm’s weighted average cost of capital assuming the firm has exhausted all retained earnings.
QUESTION 3
Celltha Sdn Bhd finds it is necessary to determine its marginal cost of capital. Celltha’s current capital structure calls for 45% debt, 15% preferred stock and 40% common equity. Initially common equity will be in the form of retained earnings and then new common stock. The course of various sources of financing are as follows: debt, 6%; preferred stock, 9%; retained earnings, 12% and new common stock, 13%.
a. What is the initial weighted average cost of capital? b. If the firm has RM20 million in retained earning, at what size capital structure will the firm run out of retained earnings? c. What will the marginal cost of capital be immediately after that point? d. The 6% cost of debt referred to above applies only to the first RM36 million of debt. After that the cost of debt will be 7%. At what size capital structure will there be a change in the cost of debt? e. What will the marginal cost of capital be immediately after that point?
d. z = Amount of lower cost debt / % of debt in the capital structure = RM36million /. = RM80 million
f. MCC = 7% (.45) + 9% (.15) + 13% (.4) = 3% + 1% + 5% = 10%
COST OF Capital Exercises
Course: Advanced Financial Management (BWFF2043)
University: Universiti Utara Malaysia
