Question

Subject 1 (30%) A. (20%) 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 el 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? (4%) b. What is the cost of the company's preferred share capital? (4 %) c. What is the cost of ABG's common equity capital using the Capital Asset Pricing (CAPM) model? (4%) d. What is the cost of ABG's common equity capital, using the dividend discount model? (4 %) 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) (4%)

Answer 1

a. Pre tax cost of ABG bond loan is 3% p.a.

After cost of ABG bond loan is 2.4 % [3% - (20% of 3%)]

b. Cost of preferred share capital = Dividend / Net proceeds from issue of shares

= (1*20%)/(3.4-0.3) = 6.45%

Net proceeds from issue of shares is market price (€ 3.4) minus disposal cost per share (€0.5)

c. cost of equity using CAPM method = Risk free rate of return + Beta coefficient ( Market Risk Rate of return - Risk free rate of return)

Hence cost of equity using CAPM method in given case = 2% + 1.4 (6% - 4%) = 4.8 %

Cost of equity using dividend discount model = (future dividend / Current market price of share) + g

Hence cost of equity using dividend discount model in given case = [(0.22 +2% of 0.22)/3.7] + 2%

= 8.06%

cost of equity as average of above two methods = (4.8 % + 8.06%) / 2 = 6.43%

d. Weighted Average cost of Capital:

Sr. No.	Particulars	Amount of capital (€)	Weight	Cost of capital	Weighted Cost of Capital
1	Bonds	1,10,00,000	0.702	2.4 %	1.6848%
2	Preference Stock	8,34,000	0.0532	6.45%	0.3431%
3	common Stock	38,35,000	0.2448	6.43%	1.5741%
		1,56,69,000	1		3.602%

Hence ABG's weighted average cost of capital is 3.602% (approx. up to 4 digits)