Question

You have been hired as a financial consultant to a company with securities listed on the Australian stock exchange. From a review of the company’s share register you have ascertained that the majority of its shareholders are resident overseas and are unable to utilise Australian imputation credits. The company is evaluating the relocation of its manufacturing plant from New South Wales to South Australia to produce its line of electronic components that are purchased by vehicle manufacturers. This new plant will cost $10 million to build and equip and is expected to have a useful life of five years. Two years ago the company paid $3 million to buy a large plot of vacant industrial land in South Australia. After the land was purchased an environmental survey found that the land was contaminated by toxic chemicals. The company spent $2 million to rehabilitate the land which reduced the toxicity levels to current international standards. The land was valued last week as being worth $6 million if sold. The company is now evaluating building the new manufacturing plant on this land. The company's Australian tax rate is 30%.

The following information on the company's existing securities was obtained from current market data. Debt: 200,000 bonds with 7 years to maturity that were issued with a face value of $100 each, paying annual coupon amounts of 8%. The current interest rate (yield) for 7-year bonds of similar risk is 9% p.a. Preference Shares: 160,000 issued shares paying a $5 annual preference dividend and currently selling for $48 per share. Ordinary Shares: 375,000 shares on issue selling for $25 per share. The beta for the company's shares is 0.9. Market Data: 13% p.a. expected return on a market portfolio; 6% p.a. risk free rate a) Calculate the project's initial Time 0 incremental amount. b) Outline the circumstances under which the company’s weighted cost of capital can be used for the required rate of return to evaluate the new plant project? c) Briefly detail why market values should be used to calculate the weighted cost of capital d) Calculate the market value of the company’s a. Debt b. Preference shares c. Ordinary shares e) Calculate the after-tax cost of the company’s a. Debt b. Preference shares c. Ordinary shares f) Briefly explain why the after-tax cost for the three sources of finance are different. g) Calculate the after-tax cost weighted cost of capital for the company

Answer 1

a]	Cost of the new plant	$     1,00,00,000
	After tax sale value of the land [opportunity
	cost] = 6000000-(6000000-5000000)*30% =	$         57,00,000
	Initial investment at t0	$     1,57,00,000
b]	The WACC of the firm can be used to evaluate
	new projects, if the new projects are as risky as
	the existing assets of the firm. In case the new
	projects have different risks, then the WACC
	should be adjusted upwards or downwards to
	reflect the appropriate risk.
c]	Market values represent the actual conditions
	prevailing in the market and hence would
	reflect the current cost of the various securites
	issued by the firm. If the firm were to raise
	capital, it would be able to do so, only at the cost
	exhibited by the market values.
	Historical values [book values] represent past
	costs.
d]	MV of debt:
	Current price of the bonds = 100/1.09^7+8*(1.09^7-1)/(0.09*1.09^7) = $94.97
	MV of debt = 94.97*200000 =	$     1,89,94,000
	MV of preference shares = 160000*48 =	$         76,80,000
	MV of equity = 375000*25 =	$         93,75,000
e]	After tax cost of debt = 9%*(1-30%) =	6.30%
	Cost of preference shares = 5/48 =	10.42%
	Cost of ordinary shares = 6%+0.9*(13%-6%) =	12.30%
f]	The cost of the various sources of finance are
	different as the risks attached to the cash flows
	of those sources are different.
	Debt has the lowest risk as, they have preference
	over preferred stock and ordinary stock when it
	comes to payment of return and repayment of
	principal. Further, interest payable on the debt is
	tax deductible, which benefit [called tax shield]
	reduces the cost of debt further.
	Preference capital has higher risk when compared
	to debt but lower risk when compared to equity.
	Besides, preference dividend is not tax deductible.
	Hence, preference capital has a cost higher than
	debt but lower than ordinary shares.
	Ordinary shares have the highest risk as they have
	rights only on the residual income and assets after
	meeting the claims of the debt and preference
	holders. Further, dividend is not tax deductible.
	Hence, ordinary shares have the highest cost
	among all the sources of finance.
g]	Source of finance	Market Value	Weight	Component Cost	WACC
	MV of debt = 94.97*200000 =	$     1,89,94,000	52.69%	6.30%	3.32%
	MV of preference shares = 160000*48 =	$         76,80,000	21.30%	10.42%	2.22%
	MV of equity = 375000*25 =	$         93,75,000	26.01%	12.30%	3.20%
	Total	$     3,60,49,000			8.74%
	WACC = 8.74%