COST OF CAPITAL EXAM QUESTIONS

QUESTION 01
WEB cooperates a low-cost airline and is a listed company. By comparison to its major competitors
it is relatively small, but it has expanded significantly in recent years. Mainly large financial
institutions hold the shares

The following are extracts from WEB Co's budgeted Statement of Financial Position at 31 May
20X2.

Capital structure $M

Ordinary shares of $1 100

Reserves 50

9% loan notes 20X5 200

(at nominal value)

Total 359

Expected dividend of $1 per share to be declared on 31 May 20X2. Due to expansion, dividends
are expected to grow at 4% a year from 1 June 20X2 for the foreseeable future.

The price per share is currently $10.40 ex div, and this is not expected to change before 31 May
20X2.

The existing loan notes are due to be redeemed at par on 31 May 20X5. The market value of these
loan notes at 1 June 20X2 is expected to be $100.84 (ex -interest) per $100 nominal.

Tax is payable on profits at a rate for of 30%.

Required

Calculate the expected weighted average cost of capital of WEB Co at 31 May 20X2. (8 marks)

QUESTION 02

(a) Compare the dividend growth model’’ and the capital asset pricing model when estimating the
cost of equity of a company.(6 marks)
(b) PAMELA Co. has a dividend payout ratio of 40% and has maintained this payout ratio for
several years. The current dividend per share of the company is TZS. 50 per share and it
expects that its next dividend per share , payable in one year’s time, will be TZS. 52 per share.

The capital of the company is as follows:

TZS.(million) TZS.(Million)
Equity
Ordinary shares ( par value TS 100 per Share) 2,500
Reserve 3,500 6,000

Debt
Bond A(par value TZS 10,000) 2,000
Bond B (par value TZS 10,000) 1,000
3,000
9,000

Bond A will be redeemed at par in ten years’ time and pays annual interest of 9%.The cost of debt
of this bond is 9.83% per year. The current ex interest market price of the bond is TZS 9,508.
Bond B will be redeemed at par in four years’ time and pays annual interest of 8%.The cost of debt
of this bon is 7.82% per year. The current ex interest market price of the bond is TZS 10,201.
PAMELA Co. has a cost of equity of 12.4%. Ignore taxation.

REQUIRED:
(i) Calculate the following values for PAMELA Co:
a. Ex- dividend share price, using the dividend growth model; (2 marks)
b. Market value weighted average cost of capital (WACC). (2 marks)

QUESTION 03

Burse Co wishes to calculate its weighted average cost of capital and the following information
relates to the company at the current time:
Number of ordinary shares 20 million
Book value of 7% convertible debt $29 million
Book value of 8% bank loan $2 million
Market price of ordinary shares $5·50 per share
Market value of convertible debt $107·11 per $100 bond
Equity beta of Burse Co 1·2
Risk-free rate of return 4·7%
Equity risk premium 6·5%
Rate of taxation 30%
Burse Co expects share prices to rise in the future at an average rate of 6% per year. The convertible
debt can be redeemed at par in eight years’ time, or converted in six years’ time into 15 shares of
Burse Co per $100 bond.
Required:
Calculate the market value weighted average cost of capital of Burse Co. State clearly any
assumptions that you make.

QUESTION 04
Coleman Technologies is considering a major expansion program that has been proposed by the
company’s information technology group. Before proceeding with the expansion, the company
needs to develop an estimate of its cost of capital. Mr. Lehman, the Financial Vice President has
provided you with the following data, which he believes may be relevant to your task of estimating
the cost of capital.
a) The firm’s tax rate is 40 percent
b) The current price of Coleman’s 12 percent coupon, semi-annual payment, and non-callable
bonds with 15 years remaining to maturity is TZS. 115.37. Coleman does not use short-
term interest-bearing debt on a permanent basis. New bonds would be privately placed with
no flotation cost.
c) The current price of the firm’s 10 percent, TZS. 1,000 per value, quarterly dividend,
perpetual preferred stock is TZS. 11,000.
d) Coleman’s common stock is currently selling at TZS. 5,000 per share. Its last dividend
(D0) was TZS. 419, and dividends are expected to grow at a constant rate of 5 percent in
the foreseeable future. Coleman’s beta is 1.2, the yield on T-bonds is 7 percent, and the
market risk premium is estimated to be 6 percent. For the bond-yield-plus-risk premium
approach, the firm uses a 4 percentage point risk premium.
e) Coleman’s target capital structure is 30 percent long term debt, 10 percent preferred stock,
and 60 percent common equity.

REQUIRED:
(i) Calculate the cost of debt and the cost of preferred equity. Comment on the differences in
the costs of the two in the light of their perceived risk.
(ii) Estimate the cost of common equity using the CAPM approach and the Discounted Cash
Flow (DCF) Approach.
(iii) Estimate the Weighted Average Cost of Capital (WACC) (Assume equity has an average
cost of the estimated in (ii)).

QUESTION 05
Safari Company wishes to calculate its weighted average cost of capital (WACC) and the
following is current information relating to the company.
Number of ordinary shares 2 million
Number of 5% ,Tshs. 100 non- callable preferred stock 1 million
Book value 10%,Tshs 1,000,irredeemable bonds Tshs. 20 million
Market price of ordinary shares Tshs. 50 cum dividend
Market price of 5%,Tshs 100 non-callable preferred stock Tshs.43 ex dividend
Total dividend just paid Tshs.4 million
Market price of 10% Tshs,1,000,irredeemable debt 105 percent ex interest
Equity beta of safari company 1.5
Treasury bill rate 5%
Expected return o the market 12%

Additional information:
1. The corporate tax rate applicable to safari company is 35%
2. The dividends of Safari Company are expected to grow at an average rate of 6%.

REQUIRED:
(a) Estimate the safari company’s equity risk premium and the cost of equity using the capital
asset pricing model (CAPM) (3 marks)
(b) Calculate the market value weighted average cot of capital of safari company using:
(i) The dividend growth model
(ii) The capital asset pricing model (12 marks)

QUESTION 06

The Finance Director of Vista Hotel has heard that the market value of the company will increase
if the weighted average cost of capital of the company is decreased. The company, which is listed
on a stock exchange, has 100 million shares in issue and the current ex div ordinary share price is
TZS2·50 per share. Vista Hotel also has in issue bonds with a book value of TZS60 million and
their current ex interest market price is TZS104 per TZS100 bond. The current after-tax cost of
debt of Vista Hotel is 7% and the tax rate is 30%. The recent dividends per share of the company
are as follows:

Year 2006 2007 2008 2009 2010

Dividend 19.38 20.20 20.41 21.02 21.8
per share
(TZS)
The Finance Director proposes to decrease the weighted average cost of capital of Vista Hotel and
hence increase its market value, by issuing TZS40 million of bonds at their par value of TZS100
per bond. These bonds would pay annual interest of 8% before tax and would be redeemed at a
5% premium to par after 10 years
Required:
i) Determine the cost of equity capital of the company. (4 marks)

ii) Calculate the weighted average cost of capital of Vista Hotel in the following circumstances:
a) before the new issue of bonds takes place; (3 marks)
b) after the new issue of bonds takes place. (3 marks)

QUESTION 07

A colleague has been taken ill. Your managing director has asked you to take over from the
colleague and to provide urgently-needed estimates of the discount rate to be used in appraising a
large new capital investment. You have been given your colleague’s working notes, which you
believe to be numerically accurate.
Working notes: Estimates for the next five years (annual averages)
Stock market total return on equity 16%
Own company dividend yield 7%
Own company share price rise 14%
Standard deviation of total stock market return on equity 10%
Systematic risk of own company return on equity 14%
Growth rate of own company earnings 12%
Growth rate of own company dividends 11%
Growth rate of own company sales 13%
Treasury bill yield 12%
The company’s gearing level (by market values) is 1 : 2 debt to equity, and after-tax earnings
available to ordinary shareholders in the most recent year were TZS54,000,000, of which
TZS21,400,000 was distributed as ordinary dividends.
The company has 1 million issued ordinary shares which are currently trading on the Stock
Exchange at TZS3.21. Corporate debt may be assumed to be risk-free. The company pays tax at
30% and personal taxation may be ignored.
Required:
Estimate the company’s weighted average cost of capital using:
i) The dividend valuation model;
ii) The capital asset pricing model.

State clearly any assumptions that you make.

Under what circumstances these models would be expected to produce similar values for the
weighted average cost of capital?

QUESTION 08

Tanko Limited (TL) is currently evaluating two different investments (Investment 1 and
Investment 2), each of which represents strategic investment in different business sectors.
At the request of the Finance Director, the Board of Directors has convened a special board
meeting to consider the appropriate discount rate, or rates, to use to evaluate the two investments.
Each of the two investments being considered is in a non-listed company and will be financed by
60% equity and 40% debt.
In the past, TL has used an estimated post-tax weighted average cost of capital of 12% to calculate
the net present value (NPV) of all investments. The Managing Director thinks this rate should
continue to be used, adjusted if necessary by plus or minus 1% or 2% to reflect greater or lesser
risk than the “average” investment
The Finance Director disagrees and suggests using the capital asset pricing model (CAPM) to
determine a discount rate that reflects the unsystematic risk of each of the proposed investments
based on proxy companies that operate in similar businesses. The Finance Director has obtained
the betas and debt ratio of two listed companies (Company A and Company B) that could be used
as proxies. These are:

Equity Debt Ratio

Beta Beta (debt: equity)
Company A 1.3 0.3 1.3
(proxy for
investment 1)
Company B 0.9 0 1.6
(proxy for
investment 2)

Other information

The expected annual post-tax return on the market is 8% and the risk-free rate
is 3%.
- Assume the debt that TL raises to finance the investment is risk-free.
- All three companies (TL, Company A and Company B) pay corporate tax at 25%.
- TL has one financial objective, which is to increase earnings each year to enable its dividend
payment to increase by 4% per annum
Required:
 a. Discuss the meaning of the term “systematic” and “unsystematic” risk and their relationship to
a company‟s equity beta. (6 Marks)
b. Using CAPM and the information given in the scenario about TL and companies A and B,
calculate for each of TL‟s proposed investments:
i. An asset beta. (4 Marks)
ii. An appropriate discount rate to be used in the evaluation of
the investments. (4 Marks)

QUESTION 09
Amana Company’s current capital structure in book value term is depicted below.
Tshs
Equity and reserves
Ordinary shares 25,000,000
Reserves 15,000,000
5% Non-callable Preference shares (Tshs 100) 10,000,000

Non-current liabilities
10% Redeemable preference shares (Tshs 100) 20,000,000
10% irredeemable Loan notes (Tshs 1000) 10,000,000
7% convertible Loan notes (Tshs 100) 20,000,000

Bank loan 5,000,000

105,000,000
Amana ltd has an equity beta of 1.2 and the ex-dividend market value of the company’s equity is Tsh
125 million. The ex-dividend market value of the convertible bonds is Tsh 21 million and the ex-
dividend market value of non-callable preference shares is Tsh 6.25 million.The 10% Tsh 1,000
irredeemable Loan is current traded at 105 percent cum interest.
Amana Co expects share prices to rise in the future at an average rate of 6% per year. The convertible
debt can be redeemed at par in 5 years’ time, or converted in 4 years’ time into 20 shares of Burse Co
per Tsh100 bond.
The 10% redeemable preference shares are issued at discount of 5% and will be redeemed at a
premium of 5% in six years’ time. The bank loan has a fixed interest rate of 7% per year. The
security risk premium is 6% and risk free is 4%.The company tax rate is 30%.
Required:
Calculate the after-tax weighted average cost of capital of Amana Co on a market value basis