FINC6001005 FINANCIAL MANAGEMENT EVEN SEMESTER 2021-2022

TA QUESTIONS & ANSWERS

WEEK 8

9-2. (Individual or component costs of capital) Compute the cost of the following:
a. A bond that has $1,000 par value (face value) and a contract or coupon interest rate of 9 percent.
A new issue would have a flotation cost of 5 percent of the $1,100 market value. The bonds mature
in 10 years. The firm’s average tax rate is 30 percent, and its marginal tax rate is 34 percent.

b. A new common stock issue that paid a $1.80 dividend last year. The par value of the stock is $15,
and earnings per share have grown at a rate of 7 percent per year. This growth rate is expected to
continue into the foreseeable future. The company maintains a constant dividend–earnings ratio of
30 percent. The price of this stock is now $27.50, but 5 percent flotation costs (as a percent of
market price) are anticipated.

c. Internal common equity when the current market price of the common stock is $43. The expected
dividend this coming year should be $3.50, increasing thereafter at a 7 percent annual growth rate.
The corporation’s tax rate is 34 percent.

d. A preferred stock paying a 9 percent dividend on a $150 par value. If a new issue is offered,
flotation costs will be 12 percent of the current price of $175.

e. A bond selling to yield 12 percent after flotation costs, but before adjusting for the marginal
corporate tax rate of 34 percent. In other words, 12 percent is the rate that equates the net
proceeds from the bond with the present value of the future cash flows (principal and interest).

Answer

a. Net price after flotation costs = $1,100 (1 – 0.05)

= $1,045

P = $1,045

n = 10 years

v = $1,000

c = 9%

coupon payment = 9% x $ 1,000 = $90

c 1 V
P = [1- n] + n
i (1+i) (1+i)
90 1000
$1,045 = 10 + 10
(1+i) (1+i)
 I or Kb = 8.32% (using excel formula)

Afte-tax cost of debt = Kb x (1 – T)

= 8.32% x (1 – 0.34) = 5.49%

Ps: All cost of debt usually are before tax. remember the income statement.

Debt : bonds, commercial bills, bank overdraft

last year dividend (1+ g)

b. Kncs = + growth rate
market price

$ 1.80 (1+0.07)
= + 0.07
$ 27.50 (1−0.05)

= 0.1437 = 14.37%

dividend ∈ year 1
c. Kcs = + growth rate
market price

$ 3.50
= + 0.07
$ 43

= 0.1514 = 15.14%

Dp
d. Kps =
market price

0.09 x ($ 150)
=
$ 175 (1−0.12)

= 0.0877 = 8.77%

e. After-tax cost of debt = Kb (1 – T)

= 12% (1 – 0.34)
= 0.0792 or 7.92%

9-15. (Weighted average cost of capital) Crawford Enterprises is a publicly held company located in
Arnold, Kansas. The firm began as a small tool and die shop but grew over its 35-year life to become
a leading supplier of metal fabrication equipment used in the farm tractor industry. At the close of
2009 the firm’s balance sheet appeared as follows:
At present, the firm’s common stock is selling for a price equal to its book value, and the firm’s
bonds are selling at par. Crawford’s managers estimate that the market requires a 15 percent return
on its common stock, the firm’s bonds command a yield to maturity of 8 percent, and the firm faces
a tax rate of 34 percent.
a. What is Crawford’s weighted average cost of capital?
b. If Crawford’s stock price were to rise such that it sold at 1.5 times book value, causing the cost of
equity to fall to 13 percent, what would the firm’s cost of capital be (assuming the cost of debt and
tax rate do not change)?

Answer

Proportion Long-term Debt = $12,590,000/ $31,475,000 = 40%

Proportion Common Equity = $18,885,000/ $31,475,000 = 60%

Product Long-term Debt = 40% x 5.28% = 0.2112 = 2.11%

Product Common Equity = 60% x 15% = 0.09 = 9%

Component Market Value Proportion Long-term Debt = $12,590,000/ $40,917,500 = 30.77%

Component Market Value proportion Common Equity = $28,327,500/ $40,917,500 = 69.23%

After tax-Cost Long-term Debt = 8%(1-34%)= 5.28%

After tax-Cost Common Equity = 13%

Product Long-term Debt = 30.77% x 5.28% = 1.62%

Product Common Equity = 69.23% x 13.00% = 9.00%

Market Value Long-term Debt = $ 12,590,000

Market Value Common Equity = 18,885,000 * 1.50 = $ 28,327,500

9-21. (Divisional costs of capital and investment decisions) Star Corporation is a provider of computer
software and IT services in two large regions of Easter Europe. The company uses 12 percent to
evaluate investments; however, due to latest developments it realized that two divisions have quite
different risks and returns. In fact, comparable companies for region 1 have equity betas of 2.0 while
in region 2 this is about 0.5. The financial manager aims to estimate the cost of capital as close to
correct as possible and tries to evaluate how acceptable investments in both regions are at 12
percent rate. The following data is available for both divisions:

a. Estimate WACC for both divisions.

b. How acceptable is the investment at 12 percent? In general, Star Corporation used 11 percent as a
cost of capital. Do you think that this appropriate? Why or why not?

Answer

Cost of Equity = using CAPM

Division 1 = Rf +β ( Rm−Rf)

= 4.5% + 2(6%)

= 16.5%

Division 2 = Rf +β ( Rm−Rf)

= 4.5% + 0.5 (6%)

= 7.5%

After tax cost of debt = Kd (1- T)

Division 1 = 6%(1-20%)

= 4.8%

Division 2 = 11%(1-20%)

= 8.8%

Mini Case 9-1

9-1. TBC Bank, based in Georgia, is growing rapidly since 2010, it introduced regional branches in
South Caucasus, has been rated as the best corporate bank in region and listed on London
international stock market. Nowadays Bank is expanding activities and needs 50,000,000 USD; Bank
has reserve in retained earnings in amount of $15,000,000, which will be used for new projects. The
CFO argued to issue bonds to finance the rest of $35,000,000. Since the bank is in a good financial
shape. There would not be any doubt regarding leverage issues; however, he also keeps in mind that
in future TBC may need to issue stocks to maintain the proper capital structure. Target capital
structure is 40 percent of debt and 60 percent of equity finance. The bank has the following bonds
outstanding: par value $1,000, 10 percent coupon rate and maturity of 15 years. Market price of
bonds is $1,100; common stock is traded at $25, paying $1.50 dividend, which is expected to grow at
5 percent; marginal tax rate is 20 percent; bond floatation cost is $15; and the stock floatation cost is
$1.

a. Calculate TBC bonds yield to maturity under market conditions.

b. What will be the cost of new debt finance? Take floatation costs into consideration.
c. What is your estimate of the cost of new equity financing raised from the sale of common stock?
d. Compute WACC.
e. Compute WACC if Bank maintains the target capital structure.
f. What you will advise the bank CEO and shareholders?

Answer