Question

You have been appointed as the Finance Manager of Shangpuri Hotel Bhd. As a finance manager, you are evaluating Project PJ10B, an investment project, and TWO (2) other additional projects namely Project Bee and Project Cee. You are required to deliver a comprehensive report explaining the application of numerous financial practices for valuing investment projects for the board of directors’ strategic decision. Your finance department has forecasted cash flows to assess the viability of Project PJ10B, Project Bee, and Project Cee incorporating risk into the calculations.

Additional information:

1. Current dividend for Shangpuri Hotel Bhd’s ordinary stock is RM2.50 and dividend growth rate is 6%.

2. Shangpuri Hotel Bhd is planning to issue new ordinary stock at RM50 with a flotation cost of 9%.

3. The company’s bond is paying a 6% coupon payment. Corporate tax stood at 30%.

4. Shangri Hotel Bhd’s capital structure comprising of 40% debt and 60% common stock.

Information related to Project PJ10B

The cost of this investment is RM1,200,000.

The investment is estimated to effectively contribute for 3 years. Ignore the residual value.

Depreciation for the Project PJ10B is subject to a straight-line method.

Further, yearly cash inflow is estimated at $900,000 and cash outflow RM400,000 per year. Cash inflow and outflow in entitle for tax benefit.

Finance department estimates discount factor at 7.0%.

Information related to Project Bee

1. Cost of this investment is RM120,000

2. Finance department estimates discount factor at 8.0%.

3. Ignore tax and depreciation.

Economy

Probability

Cash Flow

Good

0.30

RM20,000.00

Normal

0.50

RM30,000.00

Bad

0.20

RM40,000.00

Information related to Project Cee

1. Cost of this investment is RM120,000

2. Finance department estimates discount factor at 8.0%.

3. Ignore tax and depreciation.

Economy

Probability

Cash Flow

Good

0.30

RM50,000.00

Normal

0.50

RM30,000.00

Bad

0.20

RM20,000.00

Required:

QUESTION 1

a. Calculate the cost of new ordinary stock for Shangpuri Hotel Bhd. The current dividend for ordinary stock is $2.50 and the dividend is expected to grow at 6%.

b. Explain THREE (3) advantages and THREE (3) disadvantages of equity financing.

c. Calculate cost of debt for Shangpuri Hotel Bhd

d. Explain THREE (3) advantage and THREE (3) disadvantages of debt financing.

e. Calculate the weighted average cost of capital for the company

f. Explain FIVE (5) uses of WACC.

Answer 1

a. Calculate the cost of new ordinary stock for Shangpuri Hotel Bhd.

Current dividend for Shangpuri Hotel Bhd’s ordinary stock is RM2.50 and dividend growth rate is 6%.

Shangpuri Hotel Bhd is planning to issue new ordinary stock at RM50 with a flotation cost of 9%.

We will use Dividend Capitalization Formula to find the cost of equity

Re = (D1 / (P0 x (1 - f)) + g

Where:

Re = Cost of Equity

D1 = Dividends/share next year (2.50 x (1+6%)

P0 = Current share price (50)

g = Dividend growth rate (6%)

f = Floatation cost (9%)

Here D1 = D0 x (1+g) = 2.50 x (1+6%) = 2.65

Cost of equity = 2.65/ (50 x (1-9%) ) + 6%

= 2.65/ 45.5 + 6%

= 5.82% + 6%

= 11.82%

B) Advantages * Disadvantages of Equity Financing

Advantages

1. Equity financing is the permanent source of capital to company.  

2. It also provides leverage to the company. Higher the equity, higher could be the debt (as financial institutions lend based on company's own contribution in the business)

3. Management is not obligated to pay dividends. Profits can be retained and used for capital intensive projects  

Disadvantages

1. Equity has a very high cost as investor expect higher returns from investments in equity. The cost of floating equity is also high

2. One of the big risks of equity (from point of view of company) is the dilution of ownership and a possible takeover target.

3. No tax shield. Equity financing doesn't give the company any tax shield

c. Cost of Debt is ideally the after tax yield to maturity of the bond, but in absence of that information, the cost of debt is After tax coupon rate

Cost of debt = Coupon Rate x (1- Tax Rate)

= 6% x (1- 40%)

= 6% x 60%

= 3.60%  

d. Advantages & Disadvantages of Debt

Advantages

1. Debt has much lower cost that equity. After taking into account tax shields, the cost of debt is even lesser.

2. Debt can be used for both long term (for Capital Expenditure) and short term funding (for working capital funding)

3. No dilution of ownership of promoters

Disadvantages

1. Higher debt can lead to risk of bankruptcy

2. Interest as a cost has to be paid to lenders under any circumstances.

3. Key assets have to be mortgaged to avail debt increasing risk of liquidation.

e. Weighted Average cost = We X Ke + Wd x Kd

where We & Wd are weights of equity and debt respectively

Ke & Kd are costs of equity and debt (post tax)  

We = 60% & Wd = 40%

Ke = 11.82% & Kd = 3.60%

WACC = 60% x 11.82% + 40% x 3.60%

= 7.09% + 1.44%

= 8.53%

F. Uses of WACC

1. The Weighted Average Cost of Capital serves as the discount rate for calculating the Net Present Value (NPV) of a business.

2. It is also used to evaluate investment opportunities, as it is considered to represent the firm’s opportunity cost. Thus, it is used as a hurdle rate by companies.

3. WACC used in valuation of a firm and its equity, while using WACC as the discount rate

4. WACC is used in calculation of Economic value adde (EVA)

5. WACC is used in evaluation of projects with different risks.