Autumn 2005 -Questions for TBS 907 Tutorial 4- Cost of Capital- Solutions

# Autumn 2005 -Questions for TBS 907 Tutorial 4- Cost of Capital- Solutions

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TBS 907- AUTUMN 2005 TUTORIAL 4 – COST OF CAPITAL Question 1 All Figures below are quoted in ‘000s Cash and Marketable Securities 1,500 Short Term Debt 75,600 Accounts Receivable 120,000 Accounts Payable 62,000_ Inventories 125,000 Current Liabilities 137,600 Current Assets 246,500 Property, Plant, Long-Term Debt 208,600 And equipment 302,000 Deferred Taxes 45,000 Other Assets 89,000 Shareholder’s Equity 246,300 Total 637,500 Total 637,500 The above table shows a simplified balance sheet for Rensselaer Ltd. Calculate this company’s weighted- average cost of capital. The debt has just been refinanced at an interest rate of 6 percent (short-term) and 8 percent . (long-term). The average beta for the industry is 0.95 and the historical average market risk premium is 9 percent. Further interest rates for 20-year Treasury bonds are 6.5 percent and Treasury Bills are 5.3 percent. The excess return of Treasury bonds over bills is 1.2 percent. There are 7.46 million shares outstanding, and the shares are trading at \$46. The tax rate 35%. Required: a. Calculate WACC. SOLUTION: WACC = ) 1 ( t k k c d e V D V E - + Market Value of Equity = E = 7.46 million shares x \$46 = Value of Debt = D = \$208.6 m Total Value of the firm = V = = k d 8% % 35 = t c ) ( R R R k f m f e - + = β = 0.053 + 0.95 (0.09) = Therefore : WACC = ) 65 (. 08 . 3781 . 1385 . 0 6219 . ) 35 . 1 ( 08 . 76 . 551 6 . 208 1385 . 0 76 . 551 16 . 343 ) 1 ( x x x m m x m m V D V E t k k c d e + = - + = - + = 0.0861 + 0.0196 = 10.57% TBS 907 A UTUMN 2005- T UTORIAL 4 SOLUTIONS - C OST OF C APITAL P AGE 1 OF 10

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Question 2 Yummy Food has three operating divisions: Division Percentage of Firm Value Snack Foods 40 Soft Drinks 25 Breakfast Cereals 35 The Finance Director wishes to estimate divisional costs of capital and has identified three companies carrying out similar activities: Equity Beta Debt/Equity Snacky Snack Foods 1.1 0.50 Taro Soft Drinks 0.8 0.25 Sanoggs Cereals 1.3 0.30 Required: a) Estimate asset betas for each of Yummy’s divisions on the assumption that debt can be regarded as risk free. b) If Yummy’s debt to equity ratio is 0.2 what is its equity beta? c) If the risk free rate of return is 6% and the expected return on the market is 12%, what is the cost of capital for each of Yummy’s divisions? d) How reliable do you consider the costs of capital calculated in ( c) ? SOLUTION: a) Snack Foods 73 . 0 ) 15 10 ( 1 . 1 ) ) ( ( = = + = E D E E A β β Soft Drinks 64 . 0 ) 5 . 12 10 ( 8 . 0 ) ) ( ( = = + = E D E E A β β Cereals 1 ) 13 10 ( 3 . 1 ) ) ( ( = = + = E D E E A β β b) Average Assets Beta = 0.4(.73) + 0.25 (.64) + 0.35(1) = 0.292 + 0.16 +0.35 = .802 96 . 0 ) 10 12 ( 802 . 0 ) ) ( ( = = + = E E D A E β β c) Snack Foods = ) ( R R R k f m f e - + = β = .06 + 0.73 (0.12 -0.06) = 10.38% Soft Drinks = ) ( R R R k f m f e - + = β = .06 + 0.64 (0.12 -0.06) = 9.84% Cereals = ) ( R R R k f m f e - + = β = .06 + 1 (0.12 -0.06) = 12% d) This will depend on how reliable are the betas which have been calculated for each company, and how similar each of the companies is in terms of the activities to the division of the company. TBS 907 A UTUMN 2005- T UTORIAL 4 SOLUTIONS - C OST OF C APITAL P AGE 2 OF 10
Question 3 Thamos Ltd is a successful food retailing company. Over the last five years it has increased its share of the food retail market by 30%. Thamos Ltd makes no use of debt and has financed its operations entirely from retained earnings. Thamos Ltd has a current price/earnings ratio of 28 compared with the food retailing sector average of 19. Other financial data over the last five years re shown below:

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