UNIVERSITY OF DAR ES SALAAM

BUSINESS SCHOOL

DEPARTMENT OF FINANCE

FN 202: Financial Management

Additional Problems 1: Cost of Capital

1. Five years ago, Eranio plc issued 12 per cent irredeemable debentures at their par value
of £100. The current market price of these debentures is £94. If the company pays
corporation tax at a rate of 30 per cent, what is its current cost of debenture capital?
2. Pollock has in issue 1 million ordinary shares, par value 25p and £100 000 of 10 percent
irredeemable debentures. The current ex-dividend market price of the ordinary shares is
49p per share and the current ex-interest market price of the debentures is £72 per £100
par. The company has just paid a dividend of 9p per share and dividends are expected to
continue at this level indefinitely. If the company pays corporation tax at a rate of 30 per
cent, what is its weighted average cost of capital?
3. Should companies use their weighted average cost of capital as the discount rate when
assessing the acceptability of new projects?
4. MV Corporation has debt with market value of $100 million, common equity with a
book value of $100 million, and preferred stock worth $20 million outstanding. Its
common equity trades at $50 per share, and the firm has 6 million shares outstanding.
What weights should MV Corporation use in its WACC?
5. Avicorp has a $10 million debt issue outstanding, with a 6% coupon rate. The debt has
semi-annual coupons, the next coupon is due in six months, and the debt matures in five
years. It is currently priced at 95% of par value.
a. What is Avicorp’s pre-tax cost of debt?
b. If Avicorp faces a 40% tax rate, what is its after-tax cost of debt?
6. Explain why the asset beta of a company will always be lower than its equity beta unless
the company is all-equity financed.
7. Which of the following companies is likely to have the highest equity beta?
(a) A highly geared supermarket company
(b) A low-geared electricity generating company
(c) A highly geared building materials company
(d) A low-geared retail bank
(e) An industrial conglomerate financed entirely by equity

8. A firm has an equity beta of 1.30 and is currently financed by 25 per cent debt and 75
per cent equity. What will be the company’s new equity beta if the company changes its
financing to 33 per cent debt and 67 per cent equity? Assume corporation tax is 30 per
cent.
9. One-third of the total market value of Johnson plc consists of loan stock with a cost of
10 per cent. York plc is identical in every respect to Johnson except that its capital
structure is all equity and its cost of equity is 16 per cent. According to Modigliani and
Miller, if we ignored taxation and tax relief on debt capital, what would be the cost of
equity of Johnson plc?
10. Calet plc, which pays corporation tax at 30 per cent, has the following capital structure:
 Ordinary shares: 1,000,000 ordinary shares of nominal value 25p per share.
The market value of the shares is 49p per share. A dividend of 7p per share
has just been paid and dividends are expected to grow by 8 per cent per year
for the foreseeable future.
 Preference shares: 250 000 preference shares of nominal value 50p per share.
The market value of the shares is 32p per share and the annual net dividend of
7.5 percent has just been paid.
 Debentures: £100 000 of irredeemable debentures with a market price of £92
per £100 par. These debentures have a coupon rate of 10 per cent and the
annual interest payment has just been made.
Calculate the weighted average after-tax cost of capital of Calet plc.

11. Icicle Works plc is a frozen food packaging company that intends to diversify into
electronics. The project has a return of 18 per cent and Icicle Works is trying to decide
whether it should be accepted. To help it decide it is going to use the CAPM to find a
proxy beta for the project and has the following information on three electronics
companies:
 Supertronic plc: This Company has an equity beta of 1.33 and is financed by 50
per cent debt and 50 per cent equity.
 Electroland plc: This Company has an equity beta of 1.30, but it has just bought
non-electronics company with an asset beta of 1.4 that accounts for 20 per cent of
the company’s value. The company is financed by 40 per cent debt and 60 per
cent equity.
 Transelectro plc: This Company has an equity beta of 1.05 and is financed by 35
per cent debt and 65 per cent equity.
Assume that all debt is risk-free and that corporation tax is at a rate of 30 per cent.
Icicle Works plc is financed by 30 per cent debt and 70 per cent equity. The risk-free
rate of return is 10 per cent and the return on the market portfolio is 14 per cent.
Should the company accept the project?

12. Rweyemamu Ltd’s financing policy has established that the optimal capital structure is
approximately 60% ordinary equity; 10% preferred equity and 30% debt. Rweyemamu
marginal corporate tax rate is 40%.Rweyemamu needs to raise TZS 600 million to
finance a new project and has collected the following information: The current market
price of common stock is TZS 500 per share and the firm expects to pay a dividend of
TZS 55 at the end of this year. Dividends are expected to grow at a rate of 10% per year
indefinitely. In raising ordinary equity, the firm estimates that 60% will be generated
internally through retained earnings and 40% through newly issued ordinary equity.
Flotation costs of newly issued common stock will be TZS 25.Newly issued preferred
stock would have a par value of TZS 500 per share, a dividend of TZS 60 per share, and
flotation costs of TZS 17.50 per share. Rweyemamu believes that it is most likely that
new preferred equity would be issued and sold at par.
If the new debt were issued it would have a coupon rate of 9%, and maturity 10 years.
For a face value of TZS 10,000 the issue costs of debt are estimated TZS 300. It is
expected that since the investor’s opportunity cost is also 9% that new debt could be
sold at face value.
REQUIRED
Using the following information, estimate the following:
 i. The cost of current ordinary equity, the cost of new ordinary equity and the
overall cost ordinary equity component to be used in financing new project.
ii. The cost of incremental preferred stock
iii. The cost of incremental debt
iv. The weighted average cost of capital (WACC)
v. Why is the cost of retained earnings the equivalent of the firm's own required
rate of return on common stock?
vi. Why is the cost of issuing new common stock higher than the cost of retained
earnings?
vii. Why retained earnings have an opportunity cost associated?