Question

 

Speedy Gonzales is a courier services company. The company needs to replace a few of its older vehicles to improve service delivery and reduce costs. As a financial consultant, you are appointed to calculate the cost of capital.

 

The following information is presented to you in respect to the company’s capital structure:

1. 3 million R1 ordinary shares, currently trading at R4 per share
2. 2 million 12% R2 preference shares, currently trading at R3 per share
3. R1 million, 14% debentures, with a current yield-to-maturity of 11%, due in 6 years
4. Bank loan: R800 000 at 16% interest per annum, maturing in 7 years

Additional information:

The company has a beta factor of 1.5 and a risk free rate of 6%.  

Its tax rate is 30% and the return on market is 15%.

The current dividend paid on the ordinary shares is 80 cents per share and a growth rate of 13% is maintained.

Required:

3.1       Calculate the weighted average cost of capital.

(Use the Capital Asset Pricing Model to calculate the cost of equity.)                             

 

3.2       Discuss the advantages and disadvantages of using the Capital Pricing Model.               

Answer 1

The following information is presented to you in respect to the company’s capital structure:

00001. 3 million R1 ordinary shares, currently trading at R4 per share

00002. 2 million 12% R2 preference shares, currently trading at R3 per share

00003. R1 million, 14% debentures, with a current yield-to-maturity of 11%, due in 6 years

00004. Bank loan: R800 000 at 16% interest per annum, maturing in 7 years

Additional information:

The company has a beta factor of 1.5 and a risk free rate of 6%.  

Its tax rate is 30% and the return on market is 15%.

The current dividend paid on the ordinary shares is 80 cents per share and a growth rate of 13% is maintained.

.

3.1       Calculate the weighted average cost of capital (WACC).

(Use the Capital Asset Pricing Model to calculate the cost of equity)

.

Ans:

WACC = ( Cost of equity * weight ) + ( cost of preferred stock * weight ) + ( cost of debt * weight )

.

Cost of equity

Under Capital Asset Pricing Model to calculate the cost of equity,

Cost of equity = Rf + beta * ( Km - Rf )

Where,

Rf = risk free rate of 6%

Km = return on market is 15%

Beta = 1.5

.

Cost of equity = 6 + 1.5 * ( 15 - 6 )

Cost of equity = 6 + 1.5 * 9

Cost of equity = = 6 + 13.5 = 19.5%

.

cost of preferred stock = 12%

.

cost of debt = here two type of debt ( debenture and bank loan), so first calculate the weighted cost of debt

Cost of debenture = After tax yield to maturity = 11% - 30% = 7.7%

Cost of bank loan = 16 - 30% = 11.2%

Market value of debenture = 1 million

Market value of Bank loan = 800000

Total value = 1800000

Weight = Market value components / Total value

Weight of debenture = 1 million / 1800000 = 0.56

Wight of Bank loan = 800000 / 1800000 = 0.44

weighted cost of debt = ( 7.7% * 0.56 ) + ( 11.2% * 0.44 ) = 4.312 + 4.928 = 9.24%

.

Total market value of debt = 1800000

Market value of preferred stock = 2 million

Market value of equity = 3 million

Total value of capital structure = 1.8 million + 2 million + 3 million = 6.8 million

.

Weight of each components

Weight of debt = 1.8 / 6.8 = 0.265

Weight of preferred stock = 2 / 6.8 = 0.294

Weight of equity = 3 / 6.8 = 0.441

.

WACC = ( Cost of equity * weight ) + ( cost of preferred stock * weight ) + ( cost of debt * weight )

.

WACC = ( 19.5 * 0.441 ) + ( 12% * 0.294 ) + ( 9.24% * 0.265 )

WACC = 8.60 + 3.528 + 2.449 = 14.58%

.

3.2       Discuss the advantages and disadvantages of using the Capital Pricing Model.  

..

Capital Assets Pricing Model (CAPM )

The CAPM is a finance theory that establishes a linear relationship between the required return on an investment and risk. The method is based on the relations between an stock’s beta, the risk-free rate and the return on the market minus the risk-free rate, which means risk premium.

.

Advantages

>The CAPM takes into consider systematic risk which is beta of stock, which is not consider in other return models.

>The CAPM is a simple calculation that can be easily calculate the cost of equity.

.

Disadvantages

>The normally accepted rate used as the risk free rate is the return on short-term government securities such as treasury bill like something. The issue with using this input is that the return changes day by day, creating volatility. so it affect the cost also.

>The other disadvantages are assumption that used in the model, some assumption are not realistically accurate and acceptable.