Question

QUESTION FIVE Ziziq Company Limited (ZCL) is a listed company involved in agriculture its cum and processing plant are too small to meet the growing demand that it anticipat have once it gets a permit for the construction of a new dam. It therefore se cipates to expand its operations and is wary of a discount rate it can use as a hurdle rat wurdle rate in its decision making. To estimate this rate, they have been advised to consider estima the weighted average cost of capital as a basis for identifying this hurdle rate following information is available. The current capital structure is shown below Debt, 9% coupon, K1.000 par Preferred stock 8% dividend, K50 Common stock, K1 par Retained earnings TOTAL K20,000,000 K 10,000,000 K2,000,000 K68,000,000 K100,000,000 New K1,000 par bonds can be sold at par with a 10% coupon. New K25 par Preferred stock may be sold at par with a k2.50 dividend per share. Dividends on the comme stock have grown at a rate of 8% which is expected to continue. Next year's dividend la expected to be K2.00 per share and the company's common stock whose heta coefficient is 1.5, currently sells over-the-counter at K20.00 per share. The risk free rate is 6% and the return on the market portfolio is 15%. The company is in the 35% tay bracket Required: Rusell me (0) Calculate the cost of debt for ZCL. (3 marks) (i) Calculate the company's cost of preferred stock. (3 marks) (ili) Calculate the cost of equity using both the dividend growth model and the security market line. (8 marks) (iv) What is the firm's weighted average cost of capital? (4 marks) (v) Explain why many companies use their weighted average cost of capital (WACC) to evaluate capital investments, and what particular assumptions they make in using WACC for this purpose. (7 marks) Total (25 marks)

Answer 1

Answer to Question 5.

(i) Cost of Debt = Interest (1-Tax) = 9% * (1-35%) =9%*0.65 = 5.85 %

(ii) cost of preferred stock = Annual dividend/ Current market price *100

8/50*100 = 16%

(iii) cost of equity using dividend growth model = Expected divided next year/ current market price *100

Divd of current year (1+ growth rate)/ market price *100

= 2.5 (1+8%) / 20 = 2.7/20 = 13.5%

(iv) Firm's WACC = weight of debt * cost of debt + weight of Equity * cost of Equity + weight of preferred stock * cost of pref shares + cost of retained earning * weight of retained earning/ total weight

= 11.217/100 = 11.217%

Source	portfolio	weight	cost	cost *weight
Equity	20	20	13.5%	2.7
Pref shares	10	10	16%	1.6
Retained earning	68	68	10%	6.8
Debt	2	2	5.85%	0.117
Total	100	100		11.217

cost of retained earning = projected dividend / market price *100= 2/20*100= 10%

v) Mostly companies use this model to arrive at cost of capital. This is the only option to calculate cost of capital as this takes assumption of weight of each source of investment and apply the same with the cost of respective source of investment.