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Mancosa Financial Management Postgraduate MBA revision and memo
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LECTURE 1: 29/07/2023• Cost of capital
• Lease or buy options
COST OF CAPITAL: QUESTION
You have been appointed as a financial consultant by the directors of Chennai Holdings.
They require you to calculate the cost of capital of the company.
The following information is available on the capital structure of the company:
1 500 000 Ordinary shares (O/S) with a market price (MP) of R3 per share. The latest
dividend (D0) declared was 90 cents per share. A dividend growth (g) of 13% was
maintained for the past 5 years.
1 000 000 12%, R1 Preference shares (P/S) with a market value of R2 per share.
R1 000 000 9%, Debentures (D) due in 7 years and the current yield-to-maturity (YTM) is
10%.
R700 000 14% Bank loan (BL) , due in December 2025.
Additional information:
1. The company has a tax rate (Tc) of 30%.
2. The beta of the company is 1.6, a risk-free rate of 7% and the return on the market is
15%.
Required:
1.1 Calculate the weighted average cost of capital (WACC). Use the Gordon Growth Model
to calculate the cost of equity (Ke). (22 marks)
1.2 Calculate the cost of equity (Ke), using the Capital Asset Pricing Model (CAPM)
, (3 marks)
LEASE OR PURCHASE OPTIONS
X-Web Solutions needs to upgrade its mainframe computer systems. A suitable one
costs R240 000. The computer system can be leased or purchased. The terms of the
lease and purchases agreement are as follows:
Lease:
The lease would require annual end-of -year payments of R78 400 over the four years.
Maintenance cost of R8 000 per annum will be paid by the lessee. The lessee will also
purchase the asset for R26 000 at the termination of the lease.
Purchase:
The cost could be financed with Loan Shark Company. It would require a four-year
16 % loan, with annual year-end payments of R85 770.
X-Web Solutions will pay insurance and maintenance cost of R10 000 per annum.
At the end of the period the equipment will be sold at its scrap value of R20 000. The
straight-line depreciation method is used.
Interest payments for the respective four-years are R38 400; R30 820; R20 028 and
R11 830.
Additional information:
* The company is in the 30 % tax bracket and the after-tax cost of debt is 8%.
Required:
Determine the after-tax cash outflows and the net present value of the cash.
,LECTURE 1 – SOLUTIONS
COST OF CAPITAL
What is Cost of Capital?
Cost of capital is the minimum rate of return that a business must earn before generating
value. Before a business can turn a profit, it must at least generate sufficient income to
cover the cost of the capital it uses to fund its operations. This consists of both the cost of
debt and the cost of equity used for financing a business. A company’s cost of capital
depends, to a large extent, on the type of financing the company chooses to rely on – its
capital structure. The company may rely either solely on equity or solely on debt, or use a
combination of the two.
The choice of financing makes the cost of capital a crucial variable for every company, as it
will determine the company’s capital structure. Companies look for the optimal mix of
financing that provides adequate funding and minimizes the cost of capital.
STEP 1 – MARKET VALUE
O/S = NO. of O/S x MP per share = 1 500 000 x R3
= R4 500 000
P/S = NO. OF P/S x MV per share = 1 000 000 x R2
= R2 000 000
D = (PV CAPITAL) + (PV INTEREST PORTION)
= (R1000 000 X PV FACTOR) + (R90 000 X PV
CAPITAL PORTION = R1M … non-constant CF (table FACTOR)
1) …. YTM %
= (R1 000 000 X 0.5132) + (90 000 X 4.8684)
INTEREST PORTION = 9% = 513 200 + 438 156
= R1M X 9% = R90 000 … constant CF (table 2) …. = R951 356
YTM%
BL = NOT TRADED = R700 000
TOTAL = R4.5M + R2M + R951 356 + R700 000 = 8 151 356
, STEP 2 – PROPORTIONS = MV / TOTAL
O/S = 4 500 151 356
= 0.55
P/S = R2 000 000/ 8 151 356
= 0.25
D 951 151 356
= 0.12
BL 700 151 356
= 0.08
0.55 + 0,25 + 0.12 + 0.08 = 1
0.55 + 0,25 + 0.12 + 0.09 = 1.1 (incorrect)
STEP 3 – RELEVANT COST
Ke – Gordon growth model
= (D1 /P0) +g = (D1 /P0) +g
= (1.) + 13%
Where: = 47%
D1 = D0 X (1 + g)
Where:
D1 = NEXT DIVIDEND D1 = D0 X (1 + g)
D0 = LAST DIVIDEND = R0.90 x (1 + 13%)
g = GROWTH RATE = R1.02
P0 = MARKET PRICE
Kp Kp
Kp = D / P0 Kp = D / P0
= 0.12 / R2
Where: = 6%
D = P/S x % return
Where:
D = P/S x % return
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