Question

During the past years, ABG had limited its investment plans due to high cost of capital. Recently, however, the cost of capital seems to have fallen, and the management of the company is seriously considering the implementation of two major investment plans. Assume that you are the assistant of the ABG's financial director, who has assigned you to calculate the company's cost of capital. Your financial manager has provided the following information:

1. The corporate tax rate is 20%.

2. The company has issued a total of 11,000 non-callable bond with 3% annual nominal interest rate, the coupon of which is paid to the bond holders every six months. These bonds expire after 5 years, have a par value of €1,000 and are currently being traded at €1,030.40.

3. The current price of ABG's preferred stock on the stock market is €3.4 and the company has issued a total of 834,000 shares. The preferences share has a par value of €1 and a 20% dividend yield upon the par value, distributed to the stockholders twice a year. In case of issuance of new preferred share capital, the issue and disposal costs will be €0.30 per share.

4. The current market price of ABG's common stock on the stock market is €3.7 and the company has issued 3,835,000 shares. ABG's most recent dividend (Do) was €0.22 per share and dividends are expected to grow at a steady 2% annual rate for the foreseeable future. The beta coefficient of ABG is 1.4, the long-term government bond offer investors a yield of 2%, and the Expected Return of the Market is estimated to be 6%.

To help you with your task, the Financial Manager of the company has asked you to answer the following questions:

a. What is the (pre-tax) cost of the ABG bond loan and what is the final, after tax, cost of the loan capital to be included in the estimation of ABG’s weighted average cost of capital?

b. What is the cost of the company's preferred share capital?

c. What is the cost of ABG's common equity capital using the Capital Asset Pricing (CAPM) model?

d. What is the cost of ABG's common equity capital, using the dividend discount model?

e. What is ABG's Weighted Average Cost of Capital (WACC)? (Assume that the cost of equity capital is the average value of the two methods of c and d)Explain whether the dividend policy of a company affects its value, by describing the various theories that have been put forward in the literature. Provide for each theory at least two references from published papers in scientific journals (approximately 1,000 words).

Answer 1

Answer to first question in the list: a) # of semiannuals left to maturity, NPER Semiannual coupon Payment, PMT Bond's current selling price, PV Bond's maturity value at the end, FV Semiannual compounding type, TYPE Pre-tax Bond's Semiannual YTM Number of semiannuals in a year Pre-tax cost of the ABG bond loan Tax Rate After-tax Annual cost of debt 10 [25 years x 2] €165,000 [11000 x €1,000 x 3% / 2] €11,334,400 [11000 x €1030.4] €11,000,000 [11000 x €1,000] 0 = 0 if coupons paid at the end of each period; 1 if coupons paid at the beginning of each period 1.1760% [Ref: EXCEL SCREENSHOT] 2.35% (1.176% x 2] 20% 1.88% [2.35% x (1-20%)] EXCEL SCREENSHOT:

Before-tax Bond's Semiannual Yield to Maturity is calculated using EXCEL FUNCTION RATE(nper,pmt,pv,fv,type) where nper=10; pmt=-165000; pv=11334400; fv=-11000000; type=0. Here, value for pmt is input as negative figure as it denotes cash inflow; Value for fv is also negative because it denotes cash inflow; type = 0 because coupon payments are receivable at the end of each semiannual only. - K 1 # of semiannuals left to maturity, NPER 2 Semiannual coupon Payment, PMT 3 Bond's current selling price, PV 4 Bond's maturity value at the end, FV 5 Semiannual compounding type, TYPE 6 Pre-tax Bond's Semiannual YTM 7 Number of semiannuals in a year 8 Pre-tax cost of the ABG bond loan 9 Tax Rate 10 After-tax Annual cost of debt 11 B C D F G H I J =5*2 [25 years x 2] =11000*1000*3%/2 (11000 x €1,000 x 3% / 2] =11000*1030.4 (11000 x €1030.4] =11000*1000 [11000 x €1,000] 0 = 0 if coupons paid at the end of each period; 1 if coupons paid at the beginning of each period =RATE(B1,-B2,B3,-B4,B5) [Ref: EXCEL SCREENSHOT] =B6*B7 [1.176% x 2] 20% =B8*(1-B9) (2.35% x (1-20%)] b) Cost of Preferred stock = Annual preferred dividend per share / (Current price per share - Disposal cost per share) Cost of Preferred stock = (€1 x 20%)/(€3.4 - €0.30) Cost of Preferred stock = 6.45%

c) Using CAPM, Cost of Equity = Risk-free Rate + (Beta x Market Risk Premium) Cost of Equity = Risk-free Rate + [Beta x (Market Return - Risk-free Rate)] Cost of Equity = 2% + (1.4 x (6% -2%)] Cost of Equity = 2% + [1.4 x 4%] Cost of Equity = 2% + 5.6% Cost of Equity = 7.60% d) Using Dividend Growth Model (DDM), Cost of Equity = [Current Dividend x (1 + Growth Rate) / Stock Price] + Growth Rate Cost of Equity = [€0.22 x (1 + 2%) / €3.7] + 2% Cost of Equity = [€0.22 x 1.02 / €3.7] + 2% Cost of Equity = [€0.2244 / €3.7] + 2% Cost of Equity = 6.06% + 2% Cost of Equity = 8.06% e) Cost of Equity under CAPM Cost of Equity under DDM Average Cost of Equity for WACC calculation 7.60% 8.06% 7.83% [(7.60% + 8.06%)/2]

(p) (9) (p) x (q) Source # of units outstanding Market value per unit Total market value Maket value Capital Structure 0.4032 0.0920 0.5048 Debt Preferred Common 11,000 €1,030.40 €11,334,400 834,000 €3.10 €2,585,400 3,835,000 €3.70 €14,189,500 Firm's market value € 28,109,300 [€11334400 / €28109300] [€2585400 / €28109300] [€14189500 / €28109300] (p) x (9) Source Weighted Cost (p) (q) Maket Value Cost Capital (Ref: Structure NOTE) 0.4032 1.88% 0.0920 6.45% 0.5048 7.83% Company's WACC Debt Preferred Common 0.76% 0.59% 3.95% 5.31% [0.4032 x 1.88%] (0.092 x 6.45%] [0.5048 x 7.83%] [3.95% +0.59% +0.76%]