Question

You are the CFO of Dandenong Dairy Ltd. The company has an interest rate on its debt of 8 per cent per annum. The systematic risk of its equity is 1.4 and the effective company tax rate is 0.20. 30 per cent of its funding is provided by debt, while 70 per cent is provided by equity. The risk-free interest rate is 4 per cent per annum. In calculating its cost of capital, Dandenong Dairy has obtained two expert opinions as to the market risk premium (including the franking premium). One expert suggests that the market risk premium is 2 per cent per annum, while the other suggests that the market risk premium is 5 per cent per annum.

REQUIRED:

(a) What is Dandenong Dairy’s cost of capital based on these expert’s opinions of the market risk premium? Show all workings.

(b) The first expert also suggests that “It is obvious that the companies should use as much debt as possible. It is cheaper than equity and the interest is tax deductible as well.” Do you agree with the statement? Justify your answer. (c) When can the cost of capital for Dandenong Dairy be a valid measure of the cost of capital for a new project?

Answer 1

a.

Systematic risk of equity is also called Beta (B) of the equity.

Note-1 : Ke= Rf+ B ( Market Risk Premium)

where Ke= cost of equity

   B= Beta of equity

Note-2 Cost of capital or WACC = (Ke * We) + ( Kd(1-t) * Wd)

where Kd= cost of debt

We = weight of equity

Wd= weight of debt

caluculation of cost of capital

Particulars	Expert 1	Expert 2
Kd	8%	8%
Market risk premium	2%	5%
Rf	4%	4%
B (Beta)	1.4	1.4
Ke= Rf+ B* Market Risk premium	6.8%	11%
tax rate (t)	20%	20%
Kd(1-t)	6.4%	6.4%
We	0.70	0.70
Wd	0.30	0.30
Ko= (Ke * We) + ( Kd(1-t) * Wd)	6.68%	9.62%

---------------------------------------------------------------------------------

b. Yes the statement given by the first expert is correct.

- because the after tax cost of debt is 6.4% where as the cost of the equity is 6.8% and the over all cost is the company is using both debt and equity is 6.68%.

- Hence using only debt will be less costly to the company.

--------------------------------------------------------------------------------------

c. cost of capital for Dandenong Dairy be a valid measure of the cost of capital for a new project when the comapny enters into similar project with similar current capital mix.

- if the new project is not similar to current business or is having different capital mix then the cost of capital or WACC of the new project will be different.