Weighted Average Cost of Capital (WACC)
The company has been investigating a number of projects but has been unable to accurately calculate an appropriate benchmark rate for measuring these projects. You have been supplied with the following information and asked to calculate the weighted average cost of capital (WACC) for the company.
Geotech Consulting
Statement of Financial Position (extract from 30 June 2010 accounts)
Common Stock par value $2.00 4,000,000
14% Preference Shares par value $3.00 3,000,000
12% Bonds semi-annual (face value $100) 2,000,000
Term Loan 350,000
Mortgage 700,000
Additional Information:
- The ordinary shares are currently trading at $2.86 while the Preference shares are trading at $3.15.
- Return on government bonds is 4%, the market risk premium 6% and the growth rate in dividends has been consistently 3% over the past five years. A consultant has estimated the company to have a beta of 1.3.
- Corporate tax rate is 35%
- The bonds originally had a 6 year term to maturity and were issued exactly two years ago.
- The before tax return on similar risk bonds is 9%
- Interest on the term loan is 10% and the Mortgage 9%.
Required;
Calculate the weighted average cost of capital for CTRL using the market valuation approach (show your workings).
Answer:
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Weighted Average Cost of Capital (WACC)
The internal rate of return for the project is 13%. While this rate is higher than the market rate, the management would like to compare it to the company's current cost of capital. You have been provided with the following information and asked to calculate the weight average cost of capital.
The company issued 2,000 six year semi-annual bonds two years ago with a face value of $1,000 and coupon rate of 8%. The bonds are currently trading at $1150. The company also have a 9% term loan with an outstanding principal of $750,000. The only other component of debt is a $1.2 million 7.5% mortgage.
The company have three components of equity including;
- Retained earnings of $800,000
- Ordinary shares par value $3.00 $6 million
- 14% preference shares par value $5.00 $2 million
Additional Information:
- The ordinary shares are currently trading at $4.25 while the Preference shares are trading at $5.50.
- Return on government bonds is 4%, the market risk premium 7% and the growth rate in dividends has been consistently 3% over the past six years. A consultant has estimated the company to have a beta of 1.4.
- Dividends paid per ordinary share last year was $0.75
- Corporate tax rate is 35%
- The bonds are currently trading for $1150 per bond
- Interest on the term loan is 9% and the Mortgage 7.5%.
Required;
- Calculate the weighted average cost of capital for Brown Limited using the market valuation approach. (In calculating the cost of ordinary shares you should use the average based on the dividend growth and capital asset pricing model (CAPM) - show your workings).
Based on your calculation, recommend to the company what they should do in relation to the investment project (include the rationale for your recommendation)
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Clearview Ltd would like to raise capital of $10 million to fund its new project, it has the following options:
ClearviewLtd can issues bonds at a price of $985. The coupon is 8% and issue costs are 1% of the$1,000 par value. The bonds will mature in 5 years and the company tax rate is 33%;
Clearview can sell preference shares for $75 per share. The preference shares pay a $7.50dividend while issue costs of $3 per share would be incurred by the firm.
Clearviewshare is traded at $3.85 and has just paid a $0.28 dividend. The company has a beta of 1.25 and a dividend growth rate of 4.5%.The risk free rate is 5.5% and the market risk premium is 5.8%.
Clearview needs to finance its $10 million capital with the following values of debt, equity and preference shares for the company.
Debt $3,000,000
Preference Shares $1,000,000
Equity $6,000,000
Required;
- Calculate the cost of debt.
- Calculate the cost of Preference share.
- Calculate the cost of equity with two methods.
- Calculate the weighted average cost of capital Clearview limited, please use CAPM for cost of equity calculation.
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Northwest Bank has a current capital structure consisting of $250 000 of 16% (annual interest) debt and 20 000 ordinary shares. The firm pays tax at the rate of 30%.
Required:
a) Using EBIT values of $80000 and $120000, determine the associated EPS.
b) Using $80 000 of EBIT as a base, calculate the degree of financial leverage ( DFL)
Rework parts a) and b), assuming the firm has $100 000 of 16% (annual interest) debt and 30 000 ordinary shares.
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You are the financial manager for anearthmoving company in Manukau. You have been asked to assess the following purchase or lease alternatives for the acquisition of a digger. The cost of the digger if purchased is $85,000. You have also been supplied with the following information to assist you in formulating your recommendation to management.
- A five-year operating lease with annual payments in advance of $17,000. Included in the lease cost is a maintenance warrantee for the first year then after that period the lessee will be required to pay for the ongoing maintenance for the term of the lease. The lessee intends to enter into a maintenance contract to cover the remaining term of the lease costing $1500 per year.
- The company is expected to return the digger following the term of the lease.
- The company tax rate is 30% and the company's cost of capital is 11%.
- The bank has indicated that they will charge 11% on moneys borrowed.
- Under the purchase option, the digger will be depreciated straight line with 0% residual value. At the end of the fifth year the company is expected to sell the digger for $18,000.
- Assume annual compounding
- Assume that tax is paid in the year following that in which the expense had been incurred.
- The digger comes with a one year service warrantee. Following the first year the company estimates it will need to pay $1500 in advance annually for a continued service contract.
Required:
a) Calculate the net present value (NPV) for the lease and purchase option and make a recommendation as to which alternative is best. (Show workings)
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You have been asked to help a colleague choose between two companies with which she is planning to buy shares. Summary information with regard the two companies is provided below.
Capital Structure Profiles
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Company A
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Company B
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Ordinary Shares Par value $3.00
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$1,200,000
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$700,000
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Bond 10%
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$300,000
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$800,000
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The corporate tax rate is 35%.
Required:
a) Calculate the earnings per share (EPS) for each company if the level of earnings before interest and tax (EBIT) for each company is $100,000
b) Calculate the earnings per share (EPS) for each company if the level of earnings before interest and tax (EBIT) for each company is increased to $200,000.
c) Comment on the significance of your findings from questions a) and b) above?
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Question 3: Capital Structure
a) Cool Ltd has sales of 150 000 units at a price of $10 per unit. It faced fixed operating costs of $250 000 and variable operating cost of $5 per unit. The company is subject to a tax rate of 30% and has a weighted average cost of capital of 8.5%. Calculate Cool Ltd's net operating profits after taxes (NOPAT) and use it to estimate the value of the firm.
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Risk and Return and Sources of Finance
Suppose financial analysts believe there are four equally likely states of the economy: depression, recession, normal and boom. The return on the super Ltd are expected to follow the economy closely, while the returns on the Slow Ltd are not. The return predictions are as follow:
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Super Ltd Returns
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Slow Ltd Returns
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Ra
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Rb
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Depression
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-20%
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5%
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Recession
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10
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20
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Normal
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30
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-12
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Boom
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50
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9
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Required:
a) Based in the total return information provided above, calculate Mean and Standard Deviation for Super Ltd and Slow Ltd.
b) Calculate the Correlation between Super Ltd and Slow Ltd.
c) Describe the characteristics of a preference share and why this may be more attractive from both the perspective of the issuing company and investor.
d) Briefly explain the relationship between the total return, the relative return and the cumulative wealth index.
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Financial Derivatives
Required:
Martin has just purchased 5000 share of Harvey Norman at $6.15, and he has decided to write covered calls against these shares. Accordingly, he sells five Harvey Norman calls at their current market price of $0.575; the calls have three months to expiration and carry a strike price of $6.50. The shares pay a quarterly dividend of $0.08 a share.
a) Determine the total profit and holding period return Martin will generate if the share raises to $6.5 a share by the expiration date on the calls.
b) What happens to Marin's profit (and return) if the price of the share rises to more than $6.50 a share?
c) Does this covered call position offer any protection (or cushion) against a drop in the price of the share? Explain.
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Managing Foreign Exchange Exposure
The client's company, based in Australia has sold US$2,000,000 of machine parts to a US customer. The payment has been deferred for six months.
Spot exchange rate = US$1.0252/AU$
Six month forward rate = US$1.0468/AU$
Company's cost of capital = 12.0% p.a.
US 6-month deposit rate = 6.0% p.a.
US 6 month borrow rate = 9.5% p.a.
Australian 6-month borrowing rate = 7.0% p.a.
Australian 6 month deposit rate = 4.0% p.a.
Six month call option for US$2,000,000; strike price $1.055/AU$, premium price is 1.5%
The company's forecast for 6 month spot rate is $1.0500/AU$
Required;
a) Calculate the value of the sale in Australian dollars assuming the company's forecast rate and if they do not hedge. Comment on your result in light of whether or not the company should hedge.
b) Calculate and value of the proceeds from the sale if a forward market hedge is used.
c) If the company entered in a forward market hedge, calculate the foreign exchange loss or gain if the transaction had been recorded in the books at the spot rate at the time.
d) Explain and calculate the process of hedging the transaction exposure using a money market hedge.(Show workings)
e) Explain the role of interest rate differentials in your calculation in d) and calculate the implicit interest rate that would make you indifferent between the forward exchange contract and the money market hedge.
f) Calculate and explain the process of covering the transaction's exposure through the options market.
g) Based on your calculations above, which alternative would you recommend and why?
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Question Serenade Limited is a New Zealand based manufacturer who has just purchased a new machine that will be used to modernize their production line. Delivery is due in six months time. The machine was purchased in the United States at a price of US$2,400,000, payable on delivery. At present the spot rate is US$0.5050/NZ$.
Serenade's finance manager has been investigating the choice available for managing the foreign exchange exposure that the company face and has made the following estimates at who the spot rate will be in 6 months time when payment for the machine must be made.
The NZ$ will not go below US$0.7750/NZ$
The NZ$ will most likely be US$0.8150/NZ$
The NZ$ will not go above US$0.8500/NZ$
The finance manager obtained the following quotes
Six month forward rate US$0.8000/NZ$
Call option of the US$ @ 0.8100 NZ$0.02/US$
Put option of the US$ @ 0.8100 NZ$0.015/US$
Interest rate on NZ$ six month debt 7% per annum
Interest rate of US$ six month deposits 5% per annum
Required:
a) Assume Serenade decides not to cover its FX risk. What will the NZ$ cost of the machine be for each of the three future spot rate estimates made by the Finance Manager.
b) Assume Serenade take out a forward contract. What will the NZ$ cost of the machine be in six months time?
c) Which of the two option contracts given above would Serenade use to hedge their FX risk?
d) If Serenade covers its FX risk using an option, what will be the NZ$ cost of the machine based on the most likely future spot rate estimated made by the finance manager? Include all costs associated with the option that are needed to compare it with the costs of the other hedging choices.
e) If Serenade use a money market hedge to eliminate the FX risk, what will be the NZ$ cost of the machine?
f) Which of the hedging choices (unhedged, forward, option or money market hedge) would give the lowest cost of the machine based on the most likely future spot rate estimated by the finance manager? Which one would you recommend Serenade Ltd to use?
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Short Term Financial Management
ABC Ltd uses 100 000 litres of oil each year in its manufacturing process. The oil is used at a constant rate and can be purchased and received within 15 days. The firm has sufficient storage capacity for up to 50 000 litres. The firm has analysis its inventory costs and found that its order cost is $250 per order and its carrying cost is $2 per litre per year.
Calculate each of the following based on the information provided.
a) Calculate the EOQ for the company's oil.
b) Calculate the total cost of the plan suggested by the EOQ.
c) Calculate the firm's recorder point in terms of litres.
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Calculate each of the following based on the information provided.
d) If a firm has an average accounts payable balance of $34,700 and COGS of $348,000 and the operating cycle is 45 days, what will be the cash cycle?
e) You have been given the following information by the financial department.
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Particulars
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Amount
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Opening AR
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$168,750
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Closing AR
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$184,230
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Opening AP
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$146,250
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Closing AP
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$96,480
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Opening Stock
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$157,612
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Closing Stock
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$205,310
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Cost of Goods Sold
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$365,942
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Credit Sales
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$649,300
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Using the information from the above table, calculate the following
1. Accounts Payable Period
2. Accounts Receivables Period
3. Inventory Period
4. Operating Cycle
5. Cash Cycle
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