Topic 7 FINC 2011 Tutorial Solutions

Topic 7 FINC 2011 Tutorial Solutions - FINC 2011 Corporate...

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FINC 2011 Corporate Finance I Tutorial Questions and Solutions Topic 7 – Company Cost of Capital DQ 4 Compare and contrast the two different models that can be used for estimating a  company’s cost of equity capital—the dividend growth model and the CAPM. Which  model is preferred? Why? A N S W E R Dividend growth model assumes growth in perpetuity which is problematic. The CAPM requires estimation of the stock Beta, the risk free rate and the market premium. In practice, the most difficult problem is using CAPM is finding the appropriate market premium and analysts are more likely to use the CAPM than the dividend growth model. DQ 6 Compare and contrast the essential features of the alternative systems of corporate  taxation—classical and dividend imputation. A N S W E R Under the classical system of taxation, earnings are taxed at the corporate rate and then distributed as dividends. Once received by the shareholder, the dividend is taxed as personal income. This double-taxation reduces the value of after tax dividends vis a vie capital gains and makes dividends less attractive then capital gains. Under the Imputation system of taxation, earnings are taxed at the corporate tax rate. If a dividend is paid by the company from this after tax earnings, the shareholder receives a credit for the payment. Effectively, the shareholder is assessed as though he/she had earned the pre-tax amount and that amount (dividend and trading credit) is assessed for tax purposes in the hands of the shareholder. The franking credit is then used to offset the tax payable. If a shareholder is in a marginal tax bracket which is less than the corporate tax rate, the shareholder is eligible to use the additional tax credit to offset tax payable on other income or receive a cash refund. The result of this system is that dividends are only taxed once at a rate determined by the shareholders marginal tax rate. Imputation results in dividends being more attractive than under the classical system.
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PQ 2 Calculate the WACC of AOI Ltd, using the following information. Statement of financial performance extract Liabilities 10% debentures ($100 par) $10,000,000 Shareholders’ funds Paid-up capital—ordinary shares ($1 par) $25,000,000 12% preference shares ($10 par) $5,000,000 Additional information The ordinary shares are currently trading at $4.20 per share.  Commonwealth government bonds trade at 5%. The return on the market portfolio is 13.5%.
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This note was uploaded on 08/22/2011 for the course FINC 2011 taught by Professor Craigmellare during the Three '10 term at University of Sydney.

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Topic 7 FINC 2011 Tutorial Solutions - FINC 2011 Corporate...

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