tutorial 9 problem set

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THE UNIVERSITY OF HONG KONG

FACULTY OF BUSINESS AND ECONOMICS

FINA1003/1310A/B/C Corporate Finance

FIRST SEMESTER, 2014-2015

Tutorial 9 Capital Budgeting IV: Chapter 14 Cost of Capital

Question 1 (Calculating Cost of Equity)

Stock in Parrothead Industries has a beta of 1.20. The market risk premium is 8

percent, and T-bills are currently yielding 4 percent. Paarrotheads most recent

dividend was $1.80 per share, and dividends are expected to grow at a 5 percent

annual rate indefinitely. If the stock sells for $34 per share, what is your best estimate

of Parrotheads cost of equity?

Question 2 (Calculating Cost of Debt)

Moldova Beef Farm issued a 25-year, 9 percent semi-annual bond 7 years ago. The

bond currently sells for 108 percent of its face value. The companys tax rate is 35

percent. What is the pretax and after-tax cost of debt? Which is more relevant, the

pretax or the after-tax cost of debt? Why?

Suppose now the book value of the debt issue is 50 million. In addition, the company

has a second debt issue on the market, a zero coupon bond with seven years left to

maturity; the book value of this issue is 170 million and the bonds sell for 58 percent

of par.

What is the companys total book value of debt? The total market value? What is your

best estimate of the after-tax cost of debt now?

Question 3 (Finding the WACC)

Given the following information for Alexandria Power Company, find the WACC.

Assume the companys tax rate is 35 percent.

Debt: 4,000 7 percent coupon bonds outstanding, 1,000 par value, 20 years to maturity,

selling for 105 percent of par; the bonds make semi-annual payments

Common stock: 90,000 shares outstanding, selling for 60 per share; the beta is 1.10

FINA1003/1310 Corporate Finance Tutorial Problem Set 9

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Preferred stock: 13,000 shares of 6 percent preferred stock outstanding, currently

selling for 110 per share

Market: 8 percent market risk premium and 6 percent risk-free rate

Question 4 (Finding the WACC)

Titan Mining Corporation has 9 million shares of common stock outstanding, 0.5

million shares of 7 percent preferred stock outstanding, and 120,000 8.5 percent

semi-annual bonds outstanding, par value $1,000 each. The common stock currently

sells for $34 per share, and has a beta of 1.20, the preferred stock currently sells for

$83 per share, and the bonds have 15 years to maturity and sell for 93 percent of par.

The market risk premium is 10 percent, T-bills are yielding 5 percent, and Titan

Minings tax rate is 35 percent.

(a) What is the firms market value capital structure?

(b) If Titan Mining is evaluating a new investment project that has the same risk as

the firms typical project, what rate should the firm use to discount the projects

cash flows?

Question 5 (Calculating Flotation Costs)

Suppose your company needs 15 million to build a new assembly line. Your target

debt-equity ratio is 0.90. The flotation cost for new equity is 10 percent, but the

flotation cost for debt is only 4 percent. Your boss has decided to fund the project by

borrowing money, because the flotation costs are lower and the needed funds are

relatively small.

(a) What do you think about the rationale behind borrowing the entire amount?

(b) What is your companys weighted average flotation cost?

(c) What is the true cost of building the new assembly line after taking flotation costs

into account? Does it matter in this case that the entire amount is being raised

from debt?


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Capital Budgeting IV: Chapter 14 Cost of Capital

(i) Cost of Capital

- The return the firms investors could expect to earn if they invest in

securities with comparable degrees of risk

- Required return for capital budgeting based on target capital structure

- A measure how the market views the risk of assets

- Capital Structure: the mix of debt and equity maintained by a firm

(ii) Required Return on Equity (Cost of Equity)

CAPM / SML )( fmfc rrrr +=

- rf: 3-month T-bill rate

- : get estimate from data company: Yahoo, Value-Line, Bloomberg

- (rm rf): historical market risk premium

Constant growth DDM: gP

Dr

gr

DP e

e

+=

=0

110

- Get estimate of growth from analysts forecasts: Yahoo, Bloomberg

- Use historical average

- g = ROE RR

Example: Tutorial 9 Question 1

(iii) Required Return on Preferred Stock

0

110

P

Dr

r

DP P

P

==


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(iv) Required Return on Debt (Cost of Debt)

- We usually focus on the cost of long-term bonds

- Use after-tax cost of debt to get WACC

- The required return is best estimated by computing the

yield-to-maturity on the existing debt

- When the bond is not traded, use rates based on the expected bond

rating

- The cost of debt is NOT the coupon rate, which represents the cost of

debt at the time of issuance, but not the current or expected cost of

debt

rd = YTM


(v) Weighted Average Cost of Capital (WACC)

- The expected rate of return on a portfolio of all the firms securities

- Company cost of capital

Three steps to calculate cost of capital:

(1) Calculate the value of each security as a proportion of the firms

market value (get the capital structure weights)

(2) Determine the required rate of return on each security

(3) Calculate a weighted average of these required returns

In estimating WACC, use the market value of the securities unless they

are not traded

- Cost of capital must be based on what investors are actually willing to

pay for the companys securities


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- Book values are often not equal to true market value of securities

Market Value of Bonds: Market price per bond number of bonds

Market Value of Equity: Market price per shares number of shares

We can use the individual costs of capital that we have computed to get

our average cost of capital for the firm

This average is the required return on our assets, based on the markets

perception of the risk of those assets

The weights are determined by how much of each type of financing that

we use; generally we use target capital structure weights

(vi) Divisional Costs of Capital

Using WACC as the discount rate is appropriate only for projects that

have the same risk as the firms current operations

- A companys WACC is for average risk projects, i.e., for projects that

are in the firms existing business

If we are looking at a project that is NOT the same risk as the firm, then

we need to determine the appropriate discount rate for that project (2

approaches)

1. Pure Play Approach

Find one or more companies that specialize in the product or service that

we are considering

- Compute the beta for each company

- Take an average

- Use that beta along with the CAPM to find the appropriate return for a

project of that risk

- Often difficult to find pure play companies


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2. Subjective Approach

Consider the projects risk relative to the firm overall

- If the project is more risky than the firm, use a discount rate greater

than the WACC

- If the project is less risky than the firm, use a discount rate less than

the WACC

You may still accept projects that you shouldnt and reject projects you

should accept, but your error rate should be lower than not considering

differential risk at all

(vii) Flotation Costs

Flotation costs are costs of issuing securities to public

- Flotation costs can be high, for example, issue 10 million worth of

stocks but get only 9 million cash

- In practice, flotation costs will be treated as incremental negative cash

flows

- Compute the (weighted) average flotation cost

- Use the target weights because the firm will issue securities in these

percentages over the long term


tutorial 9 problem set

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