CHAPTER 12: THE COST OF CAPITAL

SUGGESTED SOLUTIONS
SOLUTION TO MULTIPLE CHOICE QUESTIONS
12.1 (d) 12.6 (d)
12.2 (b) 12.7 (e)
12.3 (c) 12.8 (c)
12.4 (a) 12.9 (b)
12.5 (d) 12.10 (e)

END OF CHAPTER QUESTIONS

12.1
One of the first reasons that spring to mind, for investors purchasing shares as well as keeping
some funds in the money market is in order to diversify. This means that they are spreading
the risk of leaving funds in one investment. Another is the expectation that, because
investment in shares is generally more risky, the expected return is higher than that offered by
banks. However, the risk is greater, as some shares may not perform well, or the share market
as a whole may move down.

12.2
Investment in shares offers two potential sources of cash flow and wealth increase. The first is
in the form of dividends paid by the company, usually based on the earnings performance.
While a dividend is a share of the earnings of the company, it is in one sense also a liquidation
of the value of the share. Clearly, if management retain the cash in the business, the potential
for earning higher profits off a higher capital base (the cash retained in the business) is often
more attractive.
The second source of return which an investor may received from purchasing shares is the
capital gain when the shares are sold in the future. The amount by which the share price has
increased is a source of return to the shareholder.
Investors differ in their preference for return in the form of dividend or capital gain. An investor
who needs cash inflows, such as a retired person, will prefer a share which offers a regular
dividend, such cash flow being required for living costs. However, investors who are taking a
long term view and only want capital growth may consider a dividend as unnecessary,
especially as it attracts taxation before it is paid out.
A more balanced view however, is that payment of some dividend is generally welcomed by
most investors because it is at least a tangible form of evidence that the company is managing
its cash wisely, and is able to meet the demands of the cash outflow.

12.3
A loan is a less risky investment than the purchase of shares. Every company is obliged first to
pay the interest on its loans before profits are distributed to shareholders. Loan investors
therefore have a preferential claim in the ordinary course of business. Similarly, in the event of
liquidation of the company, loans will be repaid before shareholders receive any of their
invested funds back. Because of the higher risk of investing in shares, shareholders require a
higher expected return (with a lower probability of it being received).

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 1

12.4
The financial manager has two main functions, firstly to find profitable investment projects for
the company and secondly to find sources from which to finance those projects. Each form of
finance has a different cost, depending upon the risk as perceived by the investor.
Cost of Equity: This is the return required by shareholders before they will be persuaded to
purchase shares in the company. It is based on the expected future cash flows from the
company in the form of dividends and the selling price of the share at the end of the
investment period.
Cost of Debt: This is the cost of each loan which the company has taken out. Loans may be at
different interest rates, depending on the type of loan and the period for which the funds are
borrowed. For example a long term loan, secured over property is likely to be at a lower rate
than a short term loan.

12.5
Interest on Loan paid = 8% x R150 000 x (8months/12months)
= R8 000
Tax shield = 30% x R8 000
= R2 400
Net Cash Outflow = R8 000 - R2 400
= R5 600

12.6
Bank Overdraft Assume the prime overdraft rate
Ordinary shares Expected return well above prime
Preference shares Expected return above prime
Mortgage Debentures Rate below prime
Long Term Loan Rate above or below prime, depending on other issues

12.7
The primary reason for using a mixture of equity and debt to finance a company is to add value
to shareholders, by levering their returns upwards. This is achieved by using assets to
generate a return on assets, which is higher than the after tax cost of debt. To the extent that
funds are used to achieve a return higher than the cost, the extra return is to the credit of the
shareholders. For example, if funds can be borrowed and the net cash payment of interest
(after the benefit of the tax shield on interest) is 10%, and those funds generate returns of
15%, the additional return of 5% belongs to the shareholders and contributes toward
increasing their returns.
From a shareholders perspective, using loan capital has some risks, which are not present
with all equity financing. The contractual obligation to meet the cash payment of interest at
regular intervals creates the risk that during periods where the business may not be doing well;
the interest still has to be paid. In the worst case, if the company is not able to meet the
interest payments, the loan creditor has the right to demand an immediate repayment of the
loan.
A company therefore balances these two sources of financing in a proportion, which is ideal for
the benefit of the leverage of returns, balanced against the perceived additional risk by the
shareholders. A company with a high proportion of loan financing is said to be highly geared
and is considered to have a higher than average degree of financial risk. Equity investors
compensate for the higher risk, by requiring a higher return on their funds (a higher cost of
equity for the company).

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 2

12.8
The full term for the words "cost of capital" is actually the "weighted average marginal cost of
capital", which means the average cost of all funds which are used by a company at its target
capital structure. If the figure is, say 15%, then it follows quite logically that every project which
the company undertakes must earn at least 15% return. At that rate, all providers of capital will
be satisfied as each will receive the required rate of return for the form of financing. Any return
above 15% will add value to the ordinary shareholders, who are the beneficiaries of all residual
income.

12.9
The target capital structure is the proportion of different forms of financing which is considered
ideal by management of the company. At this proportional level of financing from the various
sources, it is considered that the balance between the downside (risk of too much debt),
against the benefit of the upside (the additional value of leverage). Determining the target
capital structure is not a mathematical exercise, although there are research methodologies
which assist in narrowing down the approximate boundaries. Management discretion and
subjective estimation is required to make a decisions regarding the target capital structure. It is
then good financial management practice to aim to keep the financing (Equity and Liability side
of the Balance Sheet), in the approximate proportion of the target capital structure.

12.10
The cost of capital is important because it provides an indication of the minimum return
acceptable on a project or for a business in order for the project or business to “pay its way” or
to break-even from an economic point of view that is,. to earn sufficient return to compensate
for the cost of the funds (both debt & equity) invested in it.
The cost of capital contributes towards answering the question “What long term investments
should be made?” in two ways: it can be used as the discount rate for discounting the forecast
cash flows to their present values, and it can also be used as the benchmark for the IRR
capital budgeting technique – indicating that projects with an IRR less than the cost of capital
should not be accepted as they do not earn sufficient compensation.
The role of the cost of capital achieving the goal of the corporate financial manager, which is
to maximise the value of the business to the owners, is twofold:
The financial manager should attempt to minimise the cost of capital, while maximising the
benefits from the different sources of long-term finance. The cost of capital acts as a
“gatekeeper” indicating which projects will add value & which will not.

12.11 WAREHAM LTD

R 3.00
Ordinary
Number Premium Share Retained
Share Total
of shares per Share Premium Income
Capital
First Issue 5,000 R 1.00 R 15,000 R 5,000 R 20,000
Second Issue 1,000 R 6.00 R 3,000 R 6,000 R 9,000
Accumulated R 540,000 R 540,000
TOTAL SHAREHOLDER CAPITAL INVESTED IN WAREHAM LTD R 569,000

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 3

12.12 MARXENTRE LTD

Finance source Amount Weight Cost W X C

Ordinary shares 580,000 70.00% 19.0% 13.30%
Debt 248,571 30.00% 10.0% 3.00%
828,571 100.00% 16.30%
This calculation not
required to find the
WACC

12.13 RECTRON
CAPITAL STRUCTURE: Rectron Ltd
400 000 Ordinary shares of R1 400,000
Share premium 300,000
Retained income 1,700,000
Ordinary Shareholder equity 2,400,000
12% Preference shares of R2 800,000 12.0%
18% Debentures 900,000 18.0%
Short term finance 400,000 10.0%
4,500,000 tax rate 30.0%

Finance source Amount Weight Cost WXC

Ordinary shares 2,400,000 53.33% 27.0% 14.40%
Preference shares 800,000 17.78% 12.0% 2.13%
Debentures 900,000 20.00% 12.6% 2.52%
Short term finance 400,000 8.89% 7.0% 0.62%
4,500,000 100.00% 19.68%
Weighted average cost of capital is in the region of 20%

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 4

12.14 SWAN INDUSTRIAL LTD

CAPITAL STRUCTURE: Swan Industrial Ltd

100 000 Ordinary shares of R3 300,000
Share premium 900,000
Retained income 3,200,000
Ordinary Shareholder equity 4,400,000
14% Preference shares of R2 500,000 14.0%
12% Debentures 500,000 12.0%
5,400,000 tax rate 30.0%

Finance source Amount Weight Cost WXC

Ordinary shares 4,400,000 81.48% 17.0% 13.85%
Preference shares 500,000 9.26% 14.0% 1.30%
Debentures 500,000 9.26% 8.4% 0.78%
5,400,000 100.00% 15.93%
Weighted average cost of capital is in the region of 16%

12.15 VALET LTD

VALET LTD
Target
Finance source Capital Cost TCS X C
Structure
Ordinary shares 70.00% 19.0% 13.30%
Debt 30.00% 12.0% 3.60%
100.00% 16.90%

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 5

12.16 CRYPTIC LTD

Cryptic Ltd
Balance Sheet on 1 January 2.02

Fixed assets 630,000 Ordinary share capital 900,000

Net current assets 270,000
900,000 900,000

Cryptic Ltd
Income Statement for the year ended 31
December 2.02

Sales 678,000
Less: cost of sales 325,000
18.0% GrossProfit 353,000
30% Operating Expenses 121,571
18.00% Profit before tax 231,429
Tax 69,429
Profit to shareholders 162,000
Dividends 162,000
Retained income 0

12.17 LALA MANDI

COST OF CAPITAL CALCULATION

SOURCE RANDS WEIGHT COST CONTRIB

Shareholders Equity 300,000 52.63% 15.0% 7.89%

10% Debentures 50,000 8.77% 7.0% 0.61%
16% Long Term Loan 70,000 12.28% 11.2% 1.38%
15% Overdraft 150,000 26.32% 10.5% 2.76%
570,000 100.00% 12.65%
Lala Mandi
Income Statement for the year ended 31
December 2.02
Sales 560,000 (a)
Less: cost of sales 340,900
GrossProfit 219,100
Operating Expenses 123,470
Profit before interest and tax 95,630 (b)
Interest 38,700 (c )
Profit before tax 56,930 (d)
Tax 17,079 (e)
Profit to shareholders 39,851 (f)
Dividends 15,940 (g)
Retained income 23,911 (h)

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 6

12.18 STERKINK LTD
COST OF CAPITAL CALCULATION
SOURCE RANDS WEIGHT COST CONTRIB

Ordinary share capital 600,000 50.00% 20.0% 10.00%

12% Debentures 420,000 35.00% 7.2% 2.52%
18% Long Term Loan 180,000 15.00% 10.8% 1.62%
1,200,000 100.00% 14.14%

Sterkink Ltd
Income Statement for the year ended
30June 2.03
Sales 1,350,000
Less: cost of sales 678,000
GrossProfit 672,000
Operating Expenses 487,900
Profit before interest and tax 184,100
Interest 66,000
Profit before tax 118,100
Tax 47,240
Profit to shareholders 118,100
Dividends 29,525
Retained income 88,575

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 7