The Cost of Capital

THE COST OF CAPITALQ1. Place the creditor's hierarchy in the correct order. (P;D)Ordinary Shareholders 1Unsecured Creditors 2Creditors with floating charges 3Preference Shareholders 4Creditors with fixed charges 5(2 marks) Q2. Gecko Co. has just paid a dividend of $0.65/share ; the current share price in the market in the stock market is $3.6. Calculate the cost of equity? (FIB)3613156159500Ke %(2 marks) Q3. A share has a current market value of 86c, and the last dividend paid by the company was 7.23c. The expected annual growth rate of dividends is 7%. Calculate the cost of equity capital? (FIB)4013205270500Ke %(2 marks) Q4. Reeve Co. is about to pay a dividend of $1 per ordinary share. The Net assets of the company are $500,000. The Earnings for the company is $180,000.The Current share price is $7 per share. Reeve Co. has in total 100,000 Ordinary shares. What is the cost of equity to the nearest whole percentage? (MCQ)27%30%33%35%(2 marks) Q5. Sago Co.'s has 5 million shares in issue & their dividend payments in the years were as follows:End of the year 20X7 20X8 20X9 20Y0 20X1Dividends ($000) 250 275 295 222 350The current share price of Sago Co is $2/share. Calculate the cost of equity? (MCQ)11%12.6%13%15.1%(2 marks) Q6. Amok Co. is about to pay a dividend of 20c per share. The share price is 300c. The rate of return is 16% & 25% of the earnings is a dividend. Calculate the cost of equity? (FIB) 3917954508500Ke %(2 marks) Q7. Which of the following is/are the assumptions used by Dividend valuation model (DVM)? (MRQ) Income stream for the shareholders are the dividends paid by the companyDividends are constant or grow at a fixed rateThe model assumes there is no need to incorporate any riskThe dividends paid by the company are till eternity (2 marks) Q8. Which of the following statements is a disadvantage for Dividend valuation model (DVM)? (MCQ)The model takes capital gains of shareholders into accountIt assumes huge cost is applicable to the issue of new sharesNo allowance is made for the taxationThe growth in earnings is incorporated(2 marks) Q9. Shares in BLACK and WHITE have a beta of 0.75. The equity risk premium is 5% and the risk-free rate of return is 3%. What is the cost of equity capital for BLACK and WHITE? (FIB)4921256223000Ke %(2 marks) Q10. The current average market return being paid on risky investments is 14%, compared with 7% on Treasury bills. Halo Co cost of equity is 17.5%. What is the beta factor? (FIB)4921256350000Beta (2 marks) Q11. The Government securities return is 7%. The overall stock market return is 11%. The expected beta is 0.9. What would be the share's expected value if it is expected to earn an annual dividend of 5.3c, with no capital growth? (FIB) 2006606096000Cents (2 marks) Q12. All companies given below operate in the same business industry. They all have same characteristics except for the fact that their capital structures are different, which are as follows:Loco Co. Choco Co. Rocco Co.Debt from the total market 27 35 49Equity from the total market 73 65 51The equity beta of Rocco Co. is 1.32 ; the equity beta of Loco Co. is 0.74.What range will Choco Co. beta fall? (MCQ)The beta of Choco Co is higher than 1.32The beta of Choco Co. is above 0.74The beta of Choco Co. is between 0.74 ; 1.32The beta of Choco Co is lower than 0.74(2 marks) Q13. Investments required return can be predicted using the Capital asset pricing model. The risk-free rate of return is 5%. Investment Beta Value Return ValueAlpha 1.5 13%Beta 0.7 15.3%Mega 1 12%Zeta 1.2 12.2%If Zeta is correctly priced then select the appropriate option for each investment? (P;D) Alpha UnderpricedBeta Correct PriceMega Overpriced(2 marks) Q14. Beak Frees Co. makes biscuits and cookies and there are some factors in the market that the investors are unable to distinguish either they are a systematic or un-systematic risk to them. Help the investors in choosing the appropriate Risk? (HA) The immediate increase in interest rates SYSTEMATIC UNSYSTEMATIC Price increments in Flour used by the company SYSTEMATIC UNSYSTEMATICThe downfall of the economy in which the company operates SYSTEMATIC UNSYSTEMATICIndustrial unrest in one of the factories SYSTEMATIC UNSYSTEMATIC (2 marks) Q15. Which of the following assumption is not related to Capital asset pricing model? (MCQ)Investors have a spread of investment in multiple companiesThere are no taxes applicableIt ignores earning a potential of the companyAll forecast made are for single period transaction(2 marks) Q16. The systematic risk of a portfolio relative to the market portfolio is measured using the beta factor. Which of the following statements is/are true? (MRQ)If Beta is greater than 1, the security is less sensitive to systematic risk than the marketIf Beta is lesser than 1, the security is less sensitive to systematic risk than the marketIf Beta equals 1, the security's exposure to systematic risk matches the marketIf Beta equals 0 the security is risk-free(2 marks) Q17. Which of the following is an advantage of Capital asset pricing model? (MCQ)It provides a basis for establishing risk-adjusted discount rates for capital investment projects.Ignores taxation for the investorsIt is unable to distinguish between dividends & capital gainsIndividual companies have different systematic risk characteristics of their shares(2 marks) Q18. The cost of equity of a company is directly unaffected by which of the following? (MCQ)The expected market returnThe company's expected betaThe expected return on the company's assetThe government securities return (2 marks) Q19. 10% irredeemable preference shares having a share price-dividend of $7/share. The tax rate is 27%. Calculate the cost of preference shares if the par value is $0.6 correct to two decimal places? (FIB) 4521207747000Kp %(2 marks) Q20. Tangerine Co. wants to invest in an Investment appraisal project. The company decided to invest using a bank loan. The company borrowed 7% $200,000 loan for the investment. What will be the cost of debt if the tax rate is 25%? (FIB)4521207175500Kd %(2 marks) Q21. 3G Co. has in issue 12% irredeemable loan notes, currently trading at $105 cum-interest.If the tax rate changes from 27% to 20% for 3G co. then the cost of debt would likely: (MCQ) Decreases to 8.4%Decreases to 9.42% Increases to 9.42%Increases to 10.3%(2 marks) Q22. A company issued their 10% irredeemable loan notes at 150. The current market price is $75. The company is paying corporation tax of 28%. What is the cost of loan notes? (FIB)4521206985000Kd %(2 marks) Q23. A company has in issue 8% redeemable debt with three years to redemption at par. The current market value of the debt is $107.59. The corporation tax rate is 30%. What is the interest cost to the company? (MCQ)$8.6$32.3$8$5.6(2 marks) Q24. A company has in issue 5% redeemable loan notes having a current market value of $103/bond. These bonds will be redeemed in three year time at par value. Calculate the cost of debt if the tax rate is 29%? (MCQ)2%2.15%2.63%3% (2 marks) Q25. A 6% irredeemable preference shares are traded for $1.5 cumulative dividend. The tax rate is 30%. What is the cost of preference shares nearest to two decimal places? (FIB) 4521207810500Kp %(2 marks) Q26. A 3% 60,000 irredeemable preference shares are being traded for $0.5 ex. Dividend. What is the cost of preference shares? (FIB)4521206985000Kp %(2 marks) Q27. A company has irredeemable loan notes currently trading at $36 ex-interest. The coupon rate is 11% and the rate of corporation tax is 30%.What is the return required by the debt providers before tax is applicable? (MCQ)21.4%27.6%30.6%33%(2 marks) Q28. Sitcom Co. has a 5% redeemable loan notes which are redeemable at a 10% premium in 5 years' time. The current market value is $100 per loan note. The tax rate is 25%. Calculate the cost of debt? (MCQ)2.7%3.53%4%5.62%(2 marks) Q29. A company has issued convertible loan notes which are due to be redeemed at a 5% discount in five years' time. The coupon rate is 7% and the current MV is $85. Alternatively, the investor can choose to convert each loan note into 10 shares in five years' time. The company pays tax at 30% per annum. The company's shares are currently worth $9 and their value is expected to grow at a rate of 4% pa. Find the post-tax cost of the convertible debt to the company? (FIB)4521207683500Kd %(2 marks) Q30. Cobol Co. has in issue 6% convertible bonds having a market value of $115. These bonds can redeem at a premium of 2% in two years' time or can be converted to 25 ordinary shares in two years. The current share price $4 and its expected growth is 3% per annum. The corporation tax rate is 29%. Calculate the net present value if discount factor is 4%? (MCQ) $1.53$4.26$8.03$10(2 marks) Q31. Fichte Co. has in issue 12% convertible bonds having a market value of $97. These bonds can be converted into 40 ordinary shares in seven years' time or can be redeemed at 12% premium in seven years' time. The current share price is $3 with an annual growth rate of 4%.The tax rate per annum is 24%. Choose whether bonds should be converted or redeemed in seven years' time? (MCQ)$108.64 Redemption $157.91 Conversion$108.64 Conversion$157.91 Redemption (2 marks) The following information is for Q32 & Q33:Trico Co. has the capital structure:Capital Structure $ m4 million $0.2 ordinary shares 0.810% irredeemable loan notes 13.58% Preference shares 10Reserves 15Total 39.3The loan notes are quoted and the ordinary shares are currently quoted at $50 and $4 respectively in the market. The cost of equity for Trico Co. is 11% and the current corporation tax is 30%. The preference shares are currently traded for $2.25 ex. Dividend. Q32. Calculate the weighted average cost of capital (WACC) for Trico Co. using the Book values? (MCQ) 8.45%10.37%11.13%11.27%(2 marks) Q33. Calculate market value weighted average cost of capital (WACC) for Trico Co.?9.24%9.97%10.79%12.38%(2 marks) Q34. Zeeman Co. has 5m $1 ordinary shares, the reserves are held at $10m and there are 15% irredeemable loan notes of $9m. The market value of ordinary shares is $5, and the loan notes are currently traded at $80. Zeeman Co. has just paid a dividend of $0.7 and its corporation tax is 26%. What is the cost of capital? (MCQ)13.98%14.23%16.76%17.89%(2 marks)THE COST OF CAPITAL (ANSWERS)Q1. Creditors (payables) hierarchy:Creditors with fixed charges 1Creditors with floating charges 2Unsecured Creditors 3Preference Shareholders 4 Ordinary Shareholders 5 Q2. 18.1%Ke = (0.65 à · 3.6) Ãâ€" 100 = 18.1% Q3. 16%Ke = (7.23 [1 + 0.07] à · 86) + 0.07 = 0.1599 0.1599 Ãâ€" 100 = 16% Q4. DGrowth = b Ãâ€" re b = (1 – [1à ·1.8]) = 0.44 re = (1.8à ·5) = 0.36g = (0.44 Ãâ€" 0.36) Ãâ€" 100 = 15.84%Ke = [1Ãâ€"(1+15.84%)] à · (7 – 1) = 0.1931 + 15.84% = 0.351Ke = 0.351 Ãâ€" 100 = 35% Q5. Bg = [(350 à · 250) 1 à · (5-1) – 1] Ãâ€" 100 = 8.8%D1 = (350 à · 5000) Ãâ€" (1 + 8.8%) = 0.076Ke = [(0.076 à · 2) + 8.8% ] Ãâ€" 100 = 12.6% Q6. 12%g = (0.75 Ãâ€" 0.16) Ãâ€" 100 = 12%D1 = 0.2 (1 + 12%) = 0.224Ke = [0.224 à · (3 – 0.2)] = 0.08 + 12% = 0.2 Ãâ€" 100 = 12% Q7. All statements below are assumption of DVM: Income stream for the shareholders are the dividends paid by the companyDividends are constant or grow at a fixed rateThe dividends paid by the company are till eternity The model assumes there is no need to incorporate any risk. This is weakness not an assumption for Dividend growth model. Q8. CThe model does not take capital gains of shareholders into accountIt assumes no cost is applicable to the issue of new sharesNo allowance is made for the taxation (Disadvantage)The growth in earnings are ignored Q9. 6.75%Ke = 3 + (5 Ãâ€" 0.75)Ke =6.75% Q10. 1.517.5% = 7 + (14 – 7) Ãâ€" (beta)Beta =1.5 Q11. 50cKe = 7 + (11 – 7) Ãâ€" (0.9) = 10.6%Share price = 5.3c à · 10.6% = 50c Q12. CThe higher the debt, the riskier the company. The higher the equity, the safer the company.Loco Co. is safer as Debt lower & Rocco Co is riskier as debt is higher which indicates that Choco Co falls between both betas as its debt is between both companies debt. Q13.Alpha OverpricedBeta UnderpricedMega Correct PriceIf Investment Zeta is correctly priced, the actual return via CAPM will be 12.2 = 5 + 1.2 (Rm – 5)Rm = 12 Investment Alpha should provide a return of 5 + 1.5 (12 – 5) = 15.5Investment Beta should provide a return of 5 + 0.7 (12 – 5) = 9.9Investment Mega provides a return of 5 + 1 (12 – 5) = 12Investment Alpha does not provide a high return so is overpriced. Investment Beta provides too high return so is underpriced. Investment Mega provides the correct return so correct priced. Q14.The immediate increase in interest rates SYSTEMATIC Price increments in Flour used by the company UNSYSTEMATICThe downfall of the economy in which the company operates SYSTEMATIC Industrial unrest in one of the factories UNSYSTEMATICSystematic risk cannot be diversified by the investorUnsystematic risk can be diversified by the investor Q15. CInvestors have a spread of investment in multiple companies (Well-diversified portfolio)There are no taxes applicable (Indication of being in a perfect capital market)It ignores earning a potential of the company (Disadvantage of DVM)All forecast made are for the single period transaction (Considers single transaction rather than multiple transactions at once) Q16.If Beta is greater than 1, the security is less sensitive to systematic risk than the market (True)If Beta is lesser than 1, the security is less sensitive to systematic risk than the market (False, It is highly sensitive to systematic risk than the market)If Beta equals 1, the security's exposure to systematic risk matches the market (True)If Beta equals 0 the security is risk-free (True) Q17. AIt provides a basis for establishing risk-adjusted discount rates for capital investment projects. (Advantage)Ignores taxation for the investors (Disadvantage)It is unable to distinguish between dividends ; capital gains (Disadvantage)Individual companies have different systematic risk characteristics of their shares (Disadvantage) Q18. CThe formula for required return is Ke = risk-free rate + beta Ãâ€" (market rate – risk-free rate) Q19. 0.86%D= 0.6 Ãâ€" 10% = 0.06Ex-Dividend = 7 – 0.06 = 6.94Kp = (0.06 à · 6.94) Ãâ€" 100 = 0.86% Q20. 5.25%Kd = 7% Ãâ€" (1 – 25%) = 0.0525 Ãâ€" 100 = 5.25% Q21. DKd = [(12% Ãâ€" 100) Ãâ€" (1 – 27%)] à · (105 – 12) = 0.094 Ãâ€" 100 = 9.42%Kd = [(12% Ãâ€" 100) Ãâ€" (1 – 20%)] à · (105 – 12) = 0.103 Ãâ€" 100 = 10.3%Increases to 10.3% Q22. 9.6%Kd = [ (10% Ãâ€" 100) Ãâ€" ( 1 – 28%) ] à · 75 = 0.096 Ãâ€" 100 = 9.6% Q23. DInterest = (8% Ãâ€" 100) Ãâ€" (1 – 30%) = $5.6 Q24. BYear Cash flow ($) DF (5%) Present value ($) DF (10%) Present Value ($)MV/Bond 0 (103) 1 (103) 1 (103)Interest 1-3 3.55 2.723 9.67 2.487 8.83Redemption 3 100 0.864 86.4 0.751 75.1NPV (6.93) (19.07)IRR = 5 + [-6.93 à · (-6.93 – (-19.07)] Ãâ€" (10 – 5) = 2.15% Q25. 4.17%D= 1 Ãâ€" 6% = 0.06Ex-Dividend = 1.5 – 0.06 = 1.44Kp = (0.06 à · 1.44) Ãâ€" 100 = 4.17% Q26. 6%D= 1 Ãâ€" 3% = 0.03Kp = (0.03 à · 0.5) Ãâ€" 100 = 6% Q27. CAs the question states before tax the calculation will be:Kd = [(11% Ãâ€" 100) à · 36] Ãâ€" 100 = 30.6% Q28. DYear Cash flow ($) DF (5%) Present value ($) DF (10%) Present Value ($)MV/Bond 0 (100) 1 (100) 1 (100)Interest 1-5 3.75 4.329 16.23 3.791 14.22Redemption 5 110 0.784 86.24 0.621 68.31NPV 2.47 (17.47)IRR = 5 + [2.47 à · (2.47 – (-17.47)] Ãâ€" (10 – 5) = 5.62% Q29. 9.7%Year Cash flow ($) DF (5%) Present value ($) DF (10%) Present Value ($)MV/Bond 0 (85) 1 (85) 1 (85)Interest 1-5 4.9 4.329 21.21 3.791 15.58Convertible 5 109.5 0.784 85.85 0.621 68NPV 22.06 (1.42)Redemption= 85 Ãâ€" 95% = 80.75Convertible= 10 Ãâ€" [9 Ãâ€" (104%)5 ] = 109.5IRR = 5 + [22.06 à · (22.06 – (-1.42)] Ãâ€" (10 – 5) = 9.7% Q30. AYear Cash flow ($) DF (4%) Present value ($)MV/Bond 0 (115) 1 (115)Interest 1-2 4.26 1.886 8.03Redemption 2 117.3 0.925 108.5NPV 1.53Redemption= 115 Ãâ€" 102% = 117.3Convertible= 25 Ãâ€" [4 Ãâ€" (103%)2 ] = 106.1 Q31. BRedemption= $97 Ãâ€" 112% = $108.64Conversion= 40 Ãâ€" [3 Ãâ€" (104%)7] = $157.91 Q32. DKp= [(8% Ãâ€" 1) à · 2.25] Ãâ€" 100 = 3.56%Kd= [(10% Ãâ€" 100) (1 – 30%)] à · 50 = 0.14 Ãâ€" 100 = 14% Book Value ($m) Cost ($m)Equity (15+0.8) 15.8 15.8 Ãâ€" 11% 1.738Preference shares 10 10 Ãâ€" 8% 0.8Debt (irredeemable) 13.5 13.5 Ãâ€"14% 1.89Total 39.3 4.428WACC = (4.428 à · 39.3) Ãâ€" 100 = 11.27% Q33. CKp= [(8% Ãâ€" 1) à · 2.25] Ãâ€" 100 = 3.56%Kd= [(10% Ãâ€" 100) (1 – 30%)] à · 50 = 0.14 Ãâ€" 100 = 14% Market Value ($m) Cost ($m)Equity 4m Ãâ€" 4 =16 16 Ãâ€" 11% 1.76Preference shares 4m Ãâ€" 2.25 = 9 9 Ãâ€" 8% 0.72Debt (irredeemable) (13.5 à · 100) Ãâ€" 50 = 6.75 6.75 Ãâ€"14% 0.945Total 31.75 3.425WACC = (3.425 à · 31.75) Ãâ€" 100 = 10.79% Q34. AKe= ($0.7 à · $5) Ãâ€" 100 = 14%Kd= [(15% Ãâ€" 100) (1 – 26%)] à · 80 = 0.1387 Ãâ€" 100 = 13.87%Market Value ($m) Cost ($m)Equity 5m Ãâ€" 5 =25 25 Ãâ€" 14% 3.5Debt (9 à · 100) Ãâ€" 80 = 7.2 7.2 Ãâ€" 13.87% 1Total 32.2 4.5WACC = (4.5 à · 32.2) Ãâ€" 100 = 13.98%