Question

1. Malaysian Government was issuing a zero coupon Treasury bill of RM100 with maturity period of 90 days at the discounted price of RM95. Compute Annual Yield to Maturity of the bill (assuming simple interest). (2 Marks) b). You have been asked to compare three alternative investments and make a recommendation. .Project A has an initial investment of RM5 million, and after-tax cashflows of RM 2.5 million a year for the next five years. Project B has no initial investment, has after-tax cash flows of RM 1 million a year for the next ten years, and a salvage value of RM2 million (from working capital). Project C has an initial investment of $10 million, another investment of RM5 million in ten years, and after-tax cashflows of RM 2.5 million a year forever. The discount rate is 10% for all three projects. Discuss the circumstances under which the weighted average cost of capital of a company could be used in investment appraisal and indicate briefly how its limitations as a discount rate could be overcome

Answer 1

1	YTM of the bond
	YTM = [Coupon payment + (Face value - Price/Term)]/[(Face value +Price)/2]
	Coupon payment	0
	Face value (RM)	100
	Price (RM)	95
	Period (years)	0.247
	YTM = [0+(100-95)/0.247] / [(100+95)/2]	20.80%

2	Project A (Amounts in RM Millions)	Year 0	Year 1 - 5
	Cash flows	-5	2.5
	Present value factor or Present value annuity factor @ 10%	1	3.7907
	Present Value	-5	9.47675
	Net Present Value = -5+9.47675 = 4.47675
	Project B	Year 0	Year 1 - 10	Year 10
	Cash flows	0	1	2
	Present value factor or Present value annuity factor @ 10%	1	6.1446	0.3855
	Present Value	0	6.1446	0.771
	Net Present Value = 0+6.1446+0.771 = 6.9156
	Project C	Year 0	Forever	Year 10
	Cash flows	-10	2.5	-5
	Present value factor or Present value annuity factor @ 10%	1	10%	0.3855
	Present Value (PV of cash flow forever = Cash flow/Discounting factor)	-10	25	-1.9275
	Net Present Value = -10+25-1.9275 = 13.0725
	Project C has the highest NPV

WACC (also known as overall cost of capital) depends on the capital structure of the company. It weighs the cost of capital of a source of capital with its proportion to the total capital. The most common way to estimate this required rate of return is to calculate the marginal cost of each of the various sources of capital and then calculate a weighted average of these costs. This weighted average is referred to as the weighted average cost of capital (WACC). The weights in this weighted average are the proportions of the various sources of capital that the company uses to support its investment program.

The weighted average cost of capital for a firm is of use in two major areas:

1. In consideration of firm’s position
2. Evaluation of proposed changes necessitating a change in the firm’s capital.

The main problem in using WACC is determination of weighted average cost of capital. These mainly relate to assignment of weights to the cost of specific source of financing.

The weights can be estimated it using one of several approaches:

1. Assume the company’s current capital structure, at market value weights for the components, represents the company’s target capital structure.
2. Examine trends in the company’s capital structure or statements by management regarding capital structure policy to infer the target capital structure.
3. Use averages of comparable companies’ capital structures as the target capital structure.