Question

Question: Tailoka is a large company with gearing debt to equity ratio by market values of 1:2.The company’...

Tailoka is a large company with gearing debt to equity ratio by market values of 1:2.The
company’s profit after tax in the most recent year were K2,700,000 of which K1,070,000
was distributed as ordinary dividends. The Company has 5 million issued ordinary
shares which are currently trading on the LUSE at K3.21.Corporate tax rate is 35% and
corporate debt is risk free.Tailoka would want to undertake a new capital project. The
project is a major diversification into a new industry. You have been tasked to provide
estimates of the discount rate to be used in evaluating this new investment.
You have been given the following information showing estimates for the next five years.
Growth rate of own company earnings12%Average Equity Beta coefficient1.5Average industry gearing (debt to equity) ratio1:3 by market valueAverage payout ratio55%Stock market total return on equity16%Growth rate of own company dividends11%Growth rate of own company sales13%Treasury bills12%Own company dividend yield7%Own company geared equity beta1.4Own company share price rise14%

Required
(a) Calculate the company’s weighted Average Cost of Capital (WACC) using the
Capital Asset Pricing Model (CAPM).
(b) Calculate the company’s weighted Average Cost of Capital (WACC) using the
dividend valuation model
(c) Describe the situations under which the above two models will produce same
values for WACC
(d) Discuss any five (5) practical problems of using CAPM in investment
appraisal.|
(e) Prepare a brief report recommending which discount rate you should use for this
investment.Information from pars (a),(b) and (c ) above may be useful.

Answer 1

(a)Company’s weighted Average Cost of Capital (WACC) using CAPM:

Cost of Equity= RFR+Beta*(Market return-RFR)

ie.12%+(1.5*(16%-12%))=

18%

After-tax Cost of the risk-free Debt

12%*(1-35%)=

7.80%

WACC

Given that the

Average industry gearing (debt to equity) ratio1:3 by market value

WACC=(Wt.e*ke)+(Wt.d*kd)

ie.(3/4*18%)+(1/4*7.8%)=

15.45%

(b) The company’s weighted Average Cost of Capital (WACC) using the DDM:

Cost of Equity=( Next dividend/Current market price)+Growth rate of dividends

ie.(((1070000/5000000)*1.11)/3.21)+0.11=

18.40%

After-tax Cost of the risk-free Debt

12%*(1-35%)=

7.80%

WACC

Given that the

Average industry gearing (debt to equity) ratio1:3 by market value

WACC=(Wt.e*ke)+(Wt.d*kd)

ie.(3/4*18.4%)+(1/4*7.8%)=

15.75%

c. Situations under which the above two models will produce same values for WACC:

1.When the costs are almost the same and

2. when the weight of each component, ie debt & equity , in the capital structure remains the same.

(d) 5 practical problems of using CAPM in investment

The formula for finding the cost of equity or required return on equity using the Capital Asset Pricing Model is:

Cost of Equity= RFR+Beta*(Market return-RFR)

Starting from here,

1. The risk-free rate it uses keeps on changing, almost constantly.

2. estimate of beta for similar companies in similar industry , is really difficult to get , as there is shortage of companies carrying on only that activity, for which the beta estimate is needed.

3. Capital structures, ie. Quantum of debt & equity of companies ,referred for estimates , as well as their respective costs , differs widely, so as to render the adoption of estimates, less meaningful.

4.AS far as market returns are concerned, whether to adopt long-term averages or short-term averages , of the combined holding period +dividend yield returns , has always been under dispute.

5. Because of all the above, estimate of risk premium becomes difficult.

6. Needless to say that the results of the investment appraisal is as good as the CAPM rate used.

e.Which discount rate to use for this investment:

Given that

Tailoka would want to undertake a new capital project. The project is a major diversification into a new industry

it is better to use the rate as per CAPM, despite its many limitations.

as it uses the new industry-specific returns & beta

unlike the DDM , which uses all the details pertinent to the current operations.

In this particular case, discount rate as per both the models are quite close , instilling more reliability.