1. Question 6
Calculation of specific costs, WACC, and WMCC. Dillon Labs has asked its financial manager to measure the cost of each specific type of capital as well as the weighted average cost of capital. The weighted average cost is to be measured by using the following weights: 40 percent long-term debt, 10 percent preferred stock, and 50 percent common stock equity (retained earnings, new common stock, or both). The firm's tax rate is 40 percent.
Debt. The firm can sell for R980 a 10-year, R1 000-par-value bond paying annual interest at a 10 percent coupon rate. A flotation cost of 3 percent of the par value is required in addition to the discount of R20 per bond.
Preferred stock/preference shares. Eight- percent (annual dividend) preferred stock having a par value of R100 can be sold for R65. An additional fee of R2 per share must be paid to the underwriters.
Common stock/ordinary shares. The firm's common stock is currently selling for R50 per share. The dividend expected to be paid at the end of the coming year (2004) is R4. Its dividend payments, which have been approximately 60 percent of earnings per share in each of the past 5 years, were as shown in the following table.
Year
Dividend
2003
R3.75
2002
3.50
2001
3.30
2000
3.15
1999
2.85
It is expected that, to sell, new common stock must be underpriced R5 per share and the firm must also pay R3 per share in flotation costs. Dividend payments are expected to continue at 60 percent of earnings.
Calculate the specific cost of each source of financing.
If earnings available to common shareholders are expected to be
R7 million, what is the breaking point associated with the exhaustion of retained earnings?
c. Determine the weighted average cost of capital between zero and the breaking point calculated in b.
d. Determine the weighted average cost of capital just beyond the breaking point calculated in b.

2. …… Question 6: COST OF CAPITAL – WACC DEBT: Kd = I + M – Bo n M + Bo 2PV
DEBT:
Kd = I + M – Bo n
M + Bo 2
PMT FV n i
= ?
= ….. + …………..
………
……………
……….
……….
= …………….
Ki = Kd (1-T)
= ………………..
= …………
PREFERENCE SHARES:
Kp = Dp Np
= …….
…….
= ……….

3. …… ± …… ORDINARY SHARES: Ks = Rf + [b x (Km – Rf)] Ks = D1 + g P0
GORDON GROWTH CAPM:
MODEL:
Ks = Rf + [b x (Km – Rf)]
Ks = D1 + g P0
= …… + ……
= ……
New Ordinary Shares:
Kn = D1 + g Nn
Growth on Div:
00 ……
01 ……
02 ……
03 ……
04 ……
…… ± …… PV FV n i

4. BREAKING POINT: BP = Af Earnings ……… W Div (60%) ……… = ……… RE ……… …….
Project = R5,6m
DEBT
…………
ORD
…………..
PREF
………..
WACC
R0 - R
ABOVE R

5. Question 7
Calculation of specific costs, WACC, and WMCC. Lang Enterprises is interested in measuring its overall cost of capital. Current investigation has gathered the following data. The firm is in the 40 percent tax bracket.
Debt. The firm can raise an unlimited amount of debt by selling R1 000 par value, 8 percent coupon interest rate, 20 year bonds on which annual interest payments will be made. To sell the issue, an average discount of R30 per bond would have to be given. The firm also must pay flotation costs of R30 per bond.
Preferred Stock//preference shares. The firm can sell 8 percent preferred stock at itsR95 per share par value. The cost of issuing and selling the preferred stock is expected to be R5 per share. An unlimited amount of preferred stock can be sold under these terms.
Common Stock/ordinary shares. The firm's common stock is currently selling for R90 per share. The firm expects to pay cash dividends of R7 per share next year. The firm's dividends have been growing at an annual rate of 6 percent, and this is expected to continue into the future. The stock must be underpriced by R7 per share, and flotation costs are expected to amount to R5 per share. The firm can sell an unlimited amount of new common stock under these terms.
Retained earnings. When measuring this cost, the firm does not concern itself with the tax bracket or brokerage fees of owners. It expects to have available R of retained earnings in the coming year; once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing.
Calculate the specific cost of each source of financing. (Round answers to the nearest .1 percent).
The firm's capital structure weights used in calculating its weighted average cost of capital are shown in the following table. (Round answer to the nearest .1 percent).
Source of capital
Weight
Long-term debt
30%
Preferred stock 20
Common stock equity 50
Total
100%
Calculate the single breaking point associated with the form's financial situation. (Hint: This point results from exhaustion of the firm's retained earnings.)
Calculate the weighted average cost of capital associated with total new financing below the breaking point calculated in (1).
Calculate the weighted average cost of capital associated with total new financing above the breaking point calculated in (1).

6. ___ ___ ____ Question 7: COST OF CAPITAL – WACC DEBT: Kd = I + M – Bo2
= ?
= ___ + ____-____
……..
_____ + ___
……….
____%
= _______%
Ki = Kd (1-T)
= ______ (__-_____)
PREFERENCE SHARES:
Kp = Dp Np
= R______
R……….
= _______%

7. ORDINARY SHARES: Ks = Rf + [b x (Km – Rf)] Ks = D1 + g P0
GORDON GROWTH CAPM:
MODEL:
Ks = Rf + [b x (Km – Rf)]
Ks = D1 + g P0
= R___ + ______
R___
= ________
= _______%
New Ordinary Shares:
Kn = D1 + g Nn
= ________%

8. BREAKING POINT: BP = Af Earnings R100 000 W Div R0_____ = 0,1m
RE R
BP = Af W
= 0,1m
0,50
= R0.2m
Project = R
DEBT
_____%
R_____
ORD
_______%
R______
PREF
______%
WACC
R0 – R
ABOVE R

9. Question 8
Integrative – WACC, WMCC, and IOS. Cartwell products has compiled the data shown in the following table for the current costs of its three basic sources of capital – long-term debt, preferred stock and common stock equity – for various ranges of new financing.
Source of capital
Range of new financing
After tax cost
Long-term debt
R0 to R
R and above 6% 8
Preferred stock
R0 and above 17
Common stock equity
R0 to R
R200,000 and above 20 24
The company's capital structure weights used in calculating its weighted average cost of capital are shown in the following table.
Source of capital
Weight
Long-term debt
40%
Preferred stock 20
Common stock equity 40
Total
100%

10. Question 8 Contd.
Determine the breaking points and ranges of total new financing associates with each source of capital
Using the data developed in a, determine the breaking points (levels of total new financing) at which the firm's weighted average cost of capital will change.
Calculate the weighted average cost of capital for each range of total new financing found in b. (Hint: There are three ranges.)
Using the results of c along with the following information on the available investment opportunities, draw the firm's weighted marginal cost of capital (WMCC) schedule and investment opportunities schedule (IOS) on the sale set of total new financing or investment (x axis) – weighted average cost of capital and IRR (y axis) axes.
Investment Internal rate Initial
opportunity of return (IRR) investment A B C D E F G H I
e. Which, if any, of the available investments do you recommend that the firm accept? Explain your answer.
LEVERAGE (EBIT-EPS)

11. Question 8: Project = R500 000 Bp ORDINARY SHARES Bp = Af W = ……….
DEBT
………..
ORD
…………
PREF
………… Bp
ORDINARY
SHARES
Bp = Af W
= ……….
……….
= ………
DEBT
Bp = ……….
……..
= ………. R
R – R

12. ABOVE R % R

13. CAPM Ks = Rf + [b x (Km – Rf)] TWO LESSONS OF INVESTMENT:
WHEN INVESTING, YOU MUST ALWAYS SEEK A RISK PREMIUM.
DON’T FORGET, ALL RETURNS ARE VARIABLE.
RISK PREMIUM:
YOU CAN INVEST IN A GOVERNMENT BOND RISK FREE.
WHY WOULD YOU INVEST IN ANYTHING OTHER THAN A GOVERNMENT BOND?
BECAUSE YOU HAVE THE POTENTIAL TO EARN A HIGHER RETURN.
HENCE, WE SAY THAT YOU MUST ALWAYS SEEK A RISK PREMIUM.

14. RISK PREMIUM (Km – Rf) = GENERAL MARKET RISK PREMIUM.
THEORETICALLY, THIS WILL BE POSITIVE.
SO, HOW DO WE FACTOR IN THE RISK PREMIUM THAT THE SPECIFIC ASSET ADDS TO THE EQUATION?

15. BETA THERE ARE TWO TYPES OF RISK THAT WE ARE INTERESTED IN?
SYSTEMATIC OR NON-DIVERSIFIABLE RISK = THIS IS A RISK THAT THE WHOLE ECONOMY IS EXPOSED TO, SUCH AS INFLATION, POLITICAL INSTABILITY, EXCHANGE RATES AND SO ON.
UNSYSTEMATIC OR DIVERSIFIABLE RISK = THIS IS A RISK THAT A PARTICULAR INDUSTRY OR BUSINESS IS EXPOSED TO, SUCH AS PROBLEMS WITH A SUPPLIER, LABOUR PROBLEMS AND SO ON.

16. BETA
SEEING AS WE CAN DO SOMETHING ABOUT DIVERSIFIABLE RISK, WE DO NOT WORRY ABOUT IT.
OUR CONCERN IS ABOUT THE NON-DIVERSIFIABLE OR SYSTEMATIC RISK.
HOW DO WE MEASURE THIS RISK?
RIGHT! THROUGH THE BETA.
YOU MEASURE THE RETURN ON THE MARKET VERSUS THE RETURN ON THE SHARE PRICE.
YOU WILL LAND UP WITH A SCATTER DIAGRAM AS A RESULT.
THE SLOPE OF THE LINE OF BEST FIT IS THE BETA.

17. _____________________
CAPM Model:
Ks = Rf + [b x (Km – Rf)]
___________________
________________
_____________________
__________________
________
_____
= ____
___
_____
____________

18. BETA SO, WHAT DOES THE BETA MEAN?
A BETA OF 1 MEANS THAT IF THE MARKET GOES UP BY, SAY 10%, THEN WE EXPECT THE SHARE PRICE TO GO UP BY 10%.
BY THE SAME TOKEN, IF THE MARKET DECLINED BY 10%, THEN WE WOULD EXPECT THE SHARE PRICE TO DECLINE BY 10% AS WELL.
THEREFORE, A BETA OF 2 MEANS THAT IF THE MARKET GOES UP BY 10%, THEN WE EXPECT THE SHARE PRICE TO GO UP BY 20%.