hubertb22lk@gmail.

com

AMH Co
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: Financial position statement extracts as at 31 December 2012 ($000)
Equity
Ordinary shares (nominal value 50 cents)
Reserves
Long-term liabilities
4% Preference shares (nominal value $1)
7% Bonds redeemable after six years
Long-term bank loan

4,000
18,000

22,000

3,000
3,000
1,000

7,000
29,000
The ordinary shares of AMH Co have an ex div market value of $5.063 per share and an ordinary dividend of 363
cents per share has just been paid. Historic dividend payments have been as follows:
Year
2008
2009
2010
2011
Dividends per share (cents)

30.9

32.2

33.6

35.0

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 $10450 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
(a) Calculate the market value weighted average cost of capital of AMH Co.
(b) Discuss why the cost of equity is greater than the cost of debt.

ABC Company
ABC Company has just paid a dividend of 35c.
The current share price is $3.25.
Calculate the Cost of Equity (Ke) using DVM.
ABC Company 2
ABC Company has just paid a dividend of 35c.
The dividend paid has grown by 4% per year for the past 5 years.
The current share price is $3.25.
Calculate the Cost of Equity (Ke) using DVM.
ABC Company 3
Company A has a Beta of 1.2.
Government bonds are currently trading at 4%.
The average return than investors in the market can expect is 15%.
Calculate the Cost of Equity using CAPM.
ABC Company 4
Company A has a Beta of 1.2.
Company B has a Beta of 1.
Government bonds are currently trading at 5%.
The average return than investors in the market can expect is 12%.
Calculate the Cost of Equity using CAPM for each company.
ABC Company 5
Company A has a Beta of 1.3.
Company B has a Beta of 1.2.
Government bonds are currently trading at 5%.
The average market risk premium is 6%.
Calculate the Cost of Equity using CAPM for each company.

hubertb22lk@gmail.com

SHORT FORM QUESTIONS

1. What is the weighted average cost of capital?
2. Set out the creditors hierarchy.
3. Why is debt cheaper to service than equity (2 reasons!)?
4. If a company has a dividend of 40c and a share price of $3.45 what is the cost of equity?
5. If the dividend in question 4 is growing at a rate of 5% what is the cost of equity?
6. What are the two types of risk mentioned in the CAPM lecture?
7. Why can we ignore unsystematic risk?
8. What type of risk is CAPM a measure of?
9. What does Beta tell us?
10. What are the assumptions of CAPM?
11. A company has a Beta of 1.3. The market risk premium is 6% and government bonds are trading at 4%. Calculate
the cost of equity using CAPM.
12. Is a company with a Beta of 1.2 a more risky or less risky investment than a company with a Beta of 1.6?
13. How is Beta calculated?
14. What are the downsides of CAPM?
A company
A company has issued 10% irredeemable debt.
The market value of the debt is $90.
The tax rate is 30%
Calculate the cost of debt (Kd).
Redeemable Debt
A Company has issued debt which is redeemable in 5 years time.
Interest is payable at 8%.
The current market value of the debt is $102.
Ignore taxation.
Calculate the Cost of Debt (Kd).
Redeemable Debt 2
A Company has issued debt which is redeemable in 5 years time.
Interest is payable at 10%.
The current market value of the debt is $104.
Tax is payable at 30%.
Calculate the Cost of Debt (Kd).
Convertible Debt
A Company has issued debt which is convertible in 5 years time.
Interest is payable at 10%.
The current market value of the debt is $120.
On conversion, investors will have a choice of either:
I. Cash at a 15% premium; or
II. 18 shares per loan note.
The current share price is $6 and it is expected to grow in value by 4% per year.
Tax is payable at 30%.
Calculate the Cost of Debt (Kd).
Preference Shares
A company has issued 8% preference shares with a nominal value of $1.
The market value of the shares is 80c.
The tax rate is 30%.
Calculate the cost of the preference shares (Kd).
Bank Debt
A company has a bank loan of $2m at an interest rate of 10%.
The tax rate is 30%.
Calculate the cost of debt (Kd).

hubertb22lk@gmail.com

WACC
Company A is funded as follows:
Balance Sheet Extract
Ordinary Shares (50c)
2000
12% Loan Notes
1500
8% Preference Shares ($1) 500
Bank Loan
750
Details on these are as follows.
The company has an equity beta of 1.2. Government bonds are currently trading at 6% and the average market risk
premium is 7%.
The Loan notes are currently trading at $106 and are redeemable at par in 5 years time.
The preference shares are trading at 92c.
The bank loan has an interest rate of 10%.
The current share price is $1.25.
The tax rate is 30%.
Calculate the Weighted Average Cost of Capital.
Capital Structure
A company has total capital of $1,000 with debt making up $300 and equity making up
$700 of the total. The companys cost of debt is 5% and cost of equity is 14%.
I. Calculate the companys current WACC.
II. Calculate the WACC if the company substitutes $200 of equity for $200 of debt causing their cost of equity to rise
to 16%.
III. Calculate the WACC if the company substitutes $300 of equity for $300 of debt causing their cost of equity to rise
to 25%.
Short Form Questions - Capital Structure
1. What is capital structure?
2. What does the traditional view suggest you can do with the WACC?
3. Why would you want to do this?
4. What other assumptions did M & M make?
5. What does the M&M model with tax suggest we should do with our capital structure?
Project Specific Discount Rate 1
Company A intends to undertake a project in an unrelated industry.
The following details are relevant:
Item
Company A Proxy Company
Equity Beta (e) 1.2
1.4
Value of Equity 1000
800
Value of Debt
400
500
The risk free rate is 4%.
The average return on the market is 12%.
Calculate a project specific discount rate.
Ignore Tax
Project Specific Discount Rate 2
Company A intends to undertake a project in an unrelated industry.
The following details are relevant:
Item
Company A Proxy Company
Equity Beta (e) 1.1
1.3
Value of Equity 1200
900
Value of Debt
500
450
The risk free rate is 4%.
The average return on the market is 12%.
The tax rate is 30%.
Calculate a project specific discount rate.
Ignore Tax

hubertb22lk@gmail.com

Project Specific Discount Rate 3

Company Alpha is financed with $1,000 of equity and $400 of debt and intends to undertake a project in an unrelated
industry. They have identified Horizon Co. as a company in the new industry with $700 of equity and $300 of debt.
Alpha Co. has a Beta of 1.3 whereas Horizon Co. has a Beta of 1.2. The risk free rate is 4% and the average return on
the market is 12%. The tax rate is 30%.
Which of the following would be the project specific discount rate for Alpha Co. when entering the new industry?

Short Form Questions

1. What are the two types of risk included in a companys equity Beta?
2. When do we use the WACC as a discount rate?
3. What is capital structure?
4. What are the steps to calculate a project specific discount rate?
5. Our business has a Beta of 1.2, debt with a market value of 100 and equity with a market value of 400. If the proxy
has a Beta of 1.4, debt with a market value of 100 and equity with a market value of 200 calculate a project specific
discount rate. The risk free rate is 4% and the average market risk premium is 7%. Ignore tax.
6. What are the 3 types of market efficiency?
7. Describe weak form market efficiency.
Phobis Co
Phobis Co has in issue 9% bonds which are redeemable at their par value of $100 in five years time.
Alternatively, each bond may be converted on that date into 20 ordinary shares of the company. The current ordinary
share price of Phobis Co is $445 and this is expected to grow at a rate of 65% per year for the foreseeable future.
Phobis Co has a cost of debt of 7% per year.
Required:
Calculate the following current values for each $100 convertible bond:
(i) market value;
(ii) floor value;
(iii) conversion premium.

Leisure International Co
The following is an extract from the Statement of Financial Position of Leisure
International Co at 30 June 20X4:
$000
Ordinary shares of 50c each
5,200
Reserves
4,850
9% preference shares of $1 each
4,500
14% irredeemable loan notes
5,000

Total long-term funds

19,550

The ordinary shares are quoted at 80c ex-div. Assume that the market estimate of the next ordinary dividend is 4c,
growing thereafter at 12% per annum indefinitely. The preference shares, which are irredeemable, are quoted at 72c
and the loan notes are quoted at par. Corporation tax is 35%.
Required:
(a) Use the relevant data above to estimate the company's weighted average cost of capital (WACC), i.e. the return
required by the providers of the three types of capital, using the respective market values as weighting factors.
(b) Explain how the capital asset pricing model would be used as an alternative method of estimating the cost of
equity, indicating what information would be required and how it would be obtained.