Management Accounting

Cost of capital solutions (slides)

Slide 4
The following information relates to NISA Ltd,

Equity Preference shares Debt

Market values 10 000 4 000 6 000

Cost of capital 10% 7% 8.5%

Required

Calculated weighted average cost of capital NISA.

Solution

Step 1 identify all permanent sources of finance

Given (Equity, Preference shares, Debt)

Step 2 Calculate market value and cost for each source identified.

Given

Step 3 Determine weight for each source in respect of total market value.

 Total market value = 20 000(10 000 + 4000 + 6000)

 Weight Equity = 10000/20000 = 50%

Preference shares = 4000/20000 = 20%
Debt = 6000/20000 = 30%

Step 4 Calculate WACC

Component Market value Weight Cost Weighted cost

Equity 10 000 0.5 0.10 0.05
Preference shares 4 000 0.2 0.07 0.014
Debt 6 000 0.3 0.085 0.026
WACC 0.09 OR 9%
 Slide 8

The following information is available for Tosan Ltd:

Current market price: R10

Expected EPS for next year R1.5
Dividend payout ratio 25% of earnings
Expected growth rate 6%

Required

Calculate cost of equity

Solution

 With the information provided only the Dividend Growth Model is appropriate.
 Cost of Equity = [ D1/ P0 ] + g
From the information we are provided with both P0 and g, however we are not given D1.
As the expected EPS is R1.5, the dividend policy is known to be 25% of earnings, D1 is
estimated as follows:
D1 = R1.5 × 0.25 = 38cents

Therefore, Ke is calculated as follows: = (0.38 /10) + 0.06 = 9.8%

Slide 9
The following information is available for Tosan Ltd:
Current market price: R10
Current year dividends R0.28
Expected growth rate 6%

Required
Calculate cost of equity

Again, we are provided with P0 and g, but we are not given D1. In this case we are given
D0 which is the current year dividend. To calculate D1 which is the future dividend, we
have to grow the current year dividend with the expected growth rate.

D1 = 0.28 × (1 + 0.06) = 30cents

Therefore, Ke = (0.3 /10) + 0.06 = 9%

 Slide 10
Given that risk-free rate is 6% and market risk premium is 4.5%
Calculate return on market portfolio.

Solution

Market risk premium = Rm - Rf

Therefore, 4.5% = Rm – 6% [Rm = 6% + 4.5% = 10.5%]

Slide 11
In the past, Nagie Ltd’s shares have been relatively volatile compared to the market,
for instance when the JSE share dropped by 22%, Nagie Ltd share price dropped by
37.4%.
Required
Calculate the beta of Nagie Ltd

Solution
Beta = % change of company’s share price
% change of market share price

Therefore, β = 37.4/22 = 1.69

Slide 12

Nagie Ltd’s current debt equity ratio is 40%. The beta for a similar company Green
Ltd with a debt equity ratio of 60% is 1.2. Calculate the unlevered beta for Green Ltd
and then calculate the levered beta for Nagie Ltd. Assume tax rate of 28%.

Solutions

βu = βL /[1 + (1 – T)(D/E)]

Unlevered beta for Green = 1.2/[1 + (1- 0.28)(0.6) = 0.84

ΒL = Βu × [1 + (1 – T) D/E]

Levered beta for Nagie = 0.84 × [1 + (1 - 0.28) × 0.4] = 1.08

 Cost of Equity Comprehensive example (Slide 13)

The par value of the shares is R200 each and they were initially issued at a premium
of R5 each. The retained earnings account for CPW Ltd have a closing balance of R130
000 000. The shares are listed on the JSE and CPW Ltd market capitalization is R300
000 000. In the past, CPW Ltd’s shares have been relatively volatile compared to the
market – for instance, when the FTSE / JSE All share Index dropped by 22% when the
financial crisis first hit between August and December 2008, CPW Ltd share price
dropped by 35%. Since then, CPW Ltd’s share price has displayed a similar sensitivity
to movements in the market.

Required

Calculate cost of equity.

Assume: Equity market participants require a return of 15% on a fully diversified

portfolio, which is 6% above the rate they could get from investing in long-term SA
government bond

Solution
As per given information, cost of capital can only be calculated using the CAPM method.

Ke = Rf + β(Rm – Rf)

Rm = 15% Rf = 15% - 6% = 9%

Rf = ?

β = ?

β = 35/22 = 1.6

Therefore, Ke = 9% + 1.6( 15% - 9%)

= 19%
 Slide 14
PQ Ltd assumes that the firm’s bond yield is 9% and the firm adds an equity risk
premium of 5% to determine the cost of equity. Calculate the cost of equity for PQ
Ltd.

Solutions

Ke = (0.09 + 0.05) = 14%

Preference shares example (Slide 16)

Wips Ltd issued 10 000 12% non-redeemable preference shares with a par value
of R100 per share. On 31 December 2018 (year-end), the ex-div market value is
R120 and cum-div market value is R135.

Required
a. Calculate total market value of preference shares.

b. Calculate the cost of preference shares

Solution

 Non- Redeemable = Perpetuity (Use the formula below)

Present value = Fixed payment

Market interest rate

a. Market value = we use ex-div market value.

Total market value = 10 000 × 120 = R1 200 000 (Present value)
Fixed payment = (10 000 × 100 × 12%) = R120 000

Therefore, Kp = 120 000/1 200 000 × 100 = 10%

 Slide 18
The books of Ph Ltd reflects a closing balance of R10 000 000 for a finance lease liability correctly
calculated using the lease implicitly rate of 12%. The finance lease is for a delivery vehicle used by
Ph. If Ph obtained a similar lease the current market related cost would be 11%. The remaining
lease period is 4years.
Assume: Should Ph take over a similar finance lease in an open market it would R12 000 00

Required
Calculate the cost of finance lease to be included in WACC calculation.

Solution

Market value = R12 000 000 (Given)

Cost = 11% × (1 – 0.28) = 7.92%

Slide 20

Riverlake Ltd issued 14% R1OO par value preference shares convertible at the option of the
preference share holder into one ordinary share for every four preference shares. The total
number of preference originally issued amount to 100 000. If the preference shares are not
converted, they will remain in existence as non-redeemable preference shares. Similar preference
shares are currently trading at a market rate of 15% and are expected to do so for the foreseeable
future. Analysts’ projections indicate that they expect Riverlake ordinary shares to be trading at
R230 per share on the date the conversion date can be exercised. The floatation costs for issuing
new preference shares amounts to R2 per share.

Required

a) Determine the value of preference shares and ordinary shares on the conversion date

b) Based on your calculations above determine the likelihood of conversion by preference

shareholders.

c) Calculate the market value and cost of preference shares for the current year.
Slide 20 - Solution

a. Market value of preference shares on the conversion date is equal to present value of the
perpetuity (If not converted it will remain in existence as non-redeemable)
PV = PMT/i
PMT = (100 × 100 000 × 14%) = R1 400 000
i = Market related interest rate = 0.15
Therefore, PV = 1 400 000/0.15 = R9 333 333

Market value of Ordinary shares on conversion date = 230 × ¼ × 100 000 = R5 750 000

b. The value of preference shares is greater than ordinary shares. Therefore, preference
shareholders will not convert to ordinary shares. For WACC calculation we use the most
likely outcome i.e. preference shares not converted.

c. Market value is R9 333 333 as calculated above.

Cost = i
PV = PMT/i
PV per share = 9 333 333/100 000 = R93.3, Then deduct floatation cost (93.3 – 2) = R91.3
PMT per share = 100 × 14% = R14
Therefore, cost = 14/91.3 × 100 = 15.3%

Slide 21 refer to Unisa Tutorial letter

 Example 2 (UJ 2018 Cost of capital question bank)

KFP issued 1 800 000 debentures at par value of R50 with a coupon rate of 12% payable
annually in arrears. The debentures are redeemable in 2 equal annual installments starting
in 10 years’ time. The current trading price per debenture is R34.18 ex-interest.
Required
Calculate the market value of debentures and the after tax cost of debentures (IRR).

Solution

Market value = 1 800 000 × 34.18 = 61 524 000

Calculation of cost

Step 1 Determine cash flows

For tax purposes KPF will get deductions in terms of section 24 J on the Interest payments. As from year 1
till year 9 interest payment is:

12% × (1 800 000 × 50) = 10 800 000

Between year 1 and year 9 no capital portion is repaid, therefore the full payment of 10 800 000 is interest
and it is deductible for tax purposes.

Tax shield = 10 800 000× 0.28 = R3 024 000

Payment after tax = 10 800 000 – 3 024 000 = R7 776 000

Cash flows for year 10 and 11.

PV = 90 000 000
N=2
I = 12%
PMT =? = 53 252 830 (Use your financial calculator)

Year 10 Shift Amort: Principle is 42 452 830 No tax effect (Not deductible)
50 228 830
Interest is 10 800 000 × 0.72 (Tax deductible) = 7 776 000

Year 11 Shift Amort: Principle is 47 547 170 No tax effect (Not deductible)
51 665 245
Interest is 5 705 660 × 0.72 (Tax deductible) = 4 108 075

CF 0 = -61 524 00
CF (1 -9) = 7 776 000
CF 10 = 50 228 830
CF 11 = 51 655 245 Therefore, IRR 14.74% = cost of debentures.