Question

i) A company is financed 60% by debt and 40% by equity. The pre-tax cost of debt is currently 10%. The Finance Director has stated that the weighted average cost of capital for the company is 9.6%. What is the cost of equity? Assume the tax rate is 40%.

a) 11.4%

b) 9.8%

c) 12%

d) 15%

ii) Ashley Ardern has been researching a vaccine for Covid-19. The cost of the research efforts has already amounted to $500,000.

If Ashley Ardern carries on the research efforts additional lab space and equipment will need to be purchased for $1,000,000 to ensure adequate social distancing is maintained. At the end of a 2 year period, it is estimated that the salvage value of the equipment will be $0.

The results of the research are expected to result in a vaccine that will generate positive cash flows for two years. The estimated after-tax operating cash inflows are $572,000 in year 1 and $744,000 in year 2. The operating cash flows are earned evenly throughout the year.

Additional working capital of $100,000 will be required at the start of the project.

The company has an after-tax required rate of return of 10% per annum.

Question: The initial investment is:

a) $900,000

b) $1,000,000

c) $1,300,000

d) $1,100,000

iii) It is estimated that the border to Tonga will not be open until 10 months from today. I have $1,600 in the bank that is earning interest of 4% monthly. How much money will I have for my holiday when the border reopens for travel? (Round to the nearest dollar)

a) $2,342.

b) $1,728.

c) $2,367.

d) $10,736.

Answer 1

(i) Compute the cost of equity using the following equation:

WACC = Cost of equity*Weight of equity + Pre-tax cost of debt*(1 - tax rate)*Weight of debt

Hence, cost of equity () is .15 or 15%. Correct option is (d)

(ii) Compute initial investment using the following equation:

Initial Investment = Fixed capital + Working Capital + Proceeds from disposal of asset

Cost incurred on research amounting to $500,000 is a sunk cost since it has already been incurred and cannot be recovered, and hence it is not a part of initial investment.

Correct option is (d)

(iii) Compute amount available at the end of ten months using the following equation:

Amount available = $2,367

Correct option is (c)