ACCA FM Syllabus E. Business Finance - WACC - Putting it all Together - Past Papers ^{1 / 1}

The following statement of financial position information relates to Tufa Co, a company listed on a large stock market which pays corporation tax at a rate of 30%.

The share capital of Tufa Co consists of $12m of ordinary shares and $5m of irredeemable preference shares.

The ordinary shares of Tufa Co have a nominal value of $0·50 per share, an ex dividend market price of $7·07 per share and a cum dividend market price of $7·52 per share. The dividend for 20X7 will be paid in the near future.

Dividends paid in recent years have been as follows:

The 5% preference shares of Tufa Co have a nominal value of $0·50 per share and an ex dividend market price of $0·31 per share.

The long-term borrowings of Tufa Co consist of $10m of loan notes and a $3m bank loan. The bank loan has a variable interest rate.

The 7% loan notes have a nominal value of $100 per loan note and a market price of $102·34 per loan note. Annual interest has just been paid and the loan notes are redeemable in four years’ time at a 5% premium to nominal value.

Required:
(a) Calculate the after-tax weighted average cost of capital of Tufa Co on a market value basis. (11 marks)

DD 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 $0·50 per share and it expects that its next dividend per share, payable in one year’s time, will be $0·52 per share.

The capital structure of the company is as follows:

Bond A will be redeemed at nominal 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 $95·08.

Bond B will be redeemed at nominal in four years’ time and pays annual interest of 8%. The cost of debt of this bond is 7·82% per year. The current ex interest market price of the bond is $102·01.

DD Co has a cost of equity of 12·4%. Ignore taxation.

Required:
(a) Calculate the following values for DD Co:

(iii) market value weighted average cost of capital. (2 marks)

The ordinary shares of Dinla Co are currently trading at $4·26 per share on an ex dividend basis and have a nominal value of $0·25 per share. Ordinary dividends are expected to grow in the future by 4% per year and a dividend of $0·25 per share has just been paid.

The 5% preference shares have an ex dividend market value of $0·56 per share and a nominal value of $1·00 per share. These shares are irredeemable.

The 6% loan notes of Dinla Co are currently trading at $95·45 per loan note on an ex interest basis and will be redeemed at their nominal value of $100 per loan note in five years’ time.

The bank loan has a fixed interest rate of 7% per year.

Dinla Co pays corporation tax at a rate of 25%.

Required:
(a) Calculate the after-tax weighted average cost of capital of Dinla Co on a market value basis. (8 marks)

It is expected that investing $20 million in the business will increase income by 5% over the first year. Approximately 40% of cost of sales and other expenses are fixed, the remainder of these costs are variable. Fixed costs will not be affected by the business expansion, while variable costs will increase in line with income.

KQK Co pays corporation tax at a rate of 30%. The company has a policy of paying out 40% of profit after tax as dividends to shareholders.

Current liabilities are expected to increase by 3% by the end of the first year following the business expansion.

Required:
(b) Discuss the circumstances under which the current weighted average cost of capital of a company could be used in investment appraisal and indicate briefly how its limitations as a discount rate could be overcome. (5 marks)

On a market value basis, GFV Co is financed 70% by equity and 30% by debt. The company has an after-tax cost of debt of 6% and an equity beta of 1·2. The risk-free rate of return is 4% and the equity risk premium is 5%.

What is the after-tax weighted average cost of capital of GFV Co?

A. 5·4%
B. 7·2%
C. 8·3%
D. 8·8%

The ordinary shares of Tinep Co have a nominal value of 50 cents per share and are currently trading on the stock market on an ex dividend basis at $5·85 per share. Tinep Co has an equity beta of 1·15.

The loan notes have a nominal value of $100 and are currently trading on the stock market on an ex interest basis at $103·50 per loan note. The interest on the loan notes is 6% per year before tax and they will be redeemed in six years’ time at a 6% premium to their nominal value.

The risk-free rate of return is 4% per year and the equity risk premium is 6% per year. Tinep Co pays corporation tax at an annual rate of 25% per year.

Required:
(a) Calculate the market value weighted average cost of capital and the book value weighted average cost of capital of Tinep Co, and comment briefly on any difference between the two values. (9 marks)

DD 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 50c per share and it expects that its next dividend per share, payable in one year’s time, will be 52c per share.

The capital structure of the company is as follows:

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 $95·08.

Bond B will be redeemed at par in four years’ time and pays annual interest of 8%. The cost of debt of this bond is 7·82% per year. The current ex interest market price of the bond is $102·01.

DD Co has a cost of equity of 12·4%. Ignore taxation.

Required:
(a) Calculate the following values for DD Co:
(iii) market value weighted average cost of capital. (2 marks)

The equity beta of Fence Co is 0•9 and the company has issued 10 million ordinary shares. The market value of each ordinary share is $7•50. The company is also financed by 7% bonds with a nominal value of $100 per bond, which will be redeemed in seven years’ time at nominal value. The bonds have a total nominal value of $14 million. Interest on the bonds has just been paid and the current market value of each bond is $107•14.

Fence Co plans to invest in a project which is different to its existing business operations and has identified a company in the same business area as the project, Hex Co. The equity beta of Hex Co is 1•2 and the company has an equity market value of $54 million. The market value of the debt of Hex Co is $12 million.

The risk-free rate of return is 4% per year and the average return on the stock market is 11% per year. Both companies pay corporation tax at a rate of 20% per year.

Required:

(a) Calculate the current weighted average cost of capital of Fence Co. (7 marks)

Card Co has in issue 8 million shares with an ex dividend market value of $7·16 per share. A dividend of 62 cents per share for 2013 has just been paid. The pattern of recent dividends is as follows:

Card Co also has in issue 8•5% bonds redeemable in five years’ time with a total nominal value of $5 million. The market value of each $100 bond is $103•42. Redemption will be at nominal value.
Card Co is planning to invest a significant amount of money into a joint venture in a new business area. It has identified a proxy company with a similar business risk to the joint venture. The proxy company has an equity beta of 1•038 and is financed 75% by equity and 25% by debt, on a market value basis.

The current risk-free rate of return is 4% and the average equity risk premium is 5%. Card Co pays profit tax at a rate of 30% per year and has an equity beta of 1•6.

Required:

Calculate the weighted average after-tax cost of capital of Card Co using a cost of equity of 12%.
(5 marks)

AMH Co wishes to calculate its current cost of capital for use as a discount rate in investment appraisal. The following financial information relates to AMH Co:

The ordinary shares of AMH Co have an ex div market value of $4·70 per share and an ordinary dividend of  36·3 cents per share has just been paid. Historic dividend payments have been as follows:

The preference shares of AMH Co are not redeemable and have an ex div market value of 40 cents per share. The 7% bonds are redeemable at a 5% premium to their nominal value of $100 per bond and have an ex interest market value of $104·50 per bond. The bank loan has a variable interest rate that has averaged 4% per year in recent years.

AMH Co pays profit tax at an annual rate of 30% per year.

Required:

Calculate the market value weighted average cost of capital of AMH Co.

(12 marks)

The statement of financial position of BKB Co provides the following information:

BKB Co has an equity beta of 1·2 and the ex-dividend market value of the company’s equity is $125 million. The ex-interest market value of the convertible bonds is $21 million and the ex-dividend market value of the preference shares is $6·25 million.

The convertible bonds of BKB Co have a conversion ratio of 19 ordinary shares per bond. The conversion date and redemption date are both on the same date in five years’ time. The current ordinary share price of BKB Co is expected to increase by 4% per year for the foreseeable future.

The overdraft has a variable interest rate which is currently 6% per year and BKB Co expects this to increase in the near future. The overdraft has not changed in size over the last financial year, although one year ago the overdraft interest rate was 4% per year. The company’s bank will not allow the overdraft to increase from its current level.

The equity risk premium is 5% per year and the risk-free rate of return is 4% per year. BKB Co pays profit tax at an annual rate of 30% per year.

Required:

(a) Calculate the market value after-tax weighted average cost of capital of BKB Co, explaining clearly any assumptions you make.

(b) Discuss why market value weighted average cost of capital is preferred to book value weighted average cost of capital when making investment decisions.

Corhig Co is a company that is listed on a major stock exchange. The company has struggled to maintain profitability in the last two years due to poor economic conditions in its home country and as a consequence it has decided not to pay a dividend in the current year. However, there are now clear signs of economic recovery and Corhig Co is optimistic that payment of dividends can be resumed in the future. Forecast financial information relating to the company is as follows:

The company is optimistic that earnings and dividends will increase after Year 3 at a constant annual rate of 3% per year.

Corhig Co currently has a before-tax cost of debt of 5% per year and an equity beta of 1•6. On a market value basis, the company is currently financed 75% by equity and 25% by debt.

During the course of the last two years the company acted to reduce its gearing and was able to redeem a large amount of debt. Since there are now clear signs of economic recovery, Corhig Co plans to raise further debt in order to modernise some of its non-current assets and to support the expected growth in earnings.

This additional debt would mean that the capital structure of the company would change and it would be financed 60% by equity and 40% by debt on a market value basis. The before-tax cost of debt of Corhig Co would increase to 6% per year and the equity beta of Corhig Co would increase to 2.

The risk-free rate of return is 4% per year and the equity risk premium is 5% per year. In order to stimulate economic activity the government has reduced profit tax rate for all large companies to 20% per year.

The current average price/earnings ratio of listed companies similar to Corhig Co is 5 times.

Required:

Calculate the current weighted average after-tax cost of capital of Corhig Co and the weighted average after-tax cost of capital following the new debt issue, and comment on the difference between the two values.

Recent financial information relating to Close Co, a stock market listed company, is as follows.

Financial analysts have forecast that the dividends of Close Co will grow in the future at a rate of 4% per year. This is slightly less than the forecast growth rate of the profit after tax (earnings) of the company, which is 5% per year.

The finance director of Close Co thinks that, considering the risk associated with expected earnings growth, an earnings yield of 11% per year can be used for valuation purposes.

Close Co has a cost of equity of 10% per year and a before-tax cost of debt of 7% per year. The 8% bonds will be redeemed at nominal value in six years’ time. Close Co pays tax at an annual rate of 30% per year and the ex-dividend share price of the company is $8·50 per share.

Required:

Calculate the weighted average after-tax cost of capital of Close Co using market values where appropriate.