Cost of Equity and WACC Analysis in Financial Management

Assignment 7 University Canada West BUSI 623: Financial Management (ONS-Winter 23-48) Instructor’s Name: Sujatha Selvaraj Due Date: 21st March 2023 Chapter 14

Q. 1. Ans: We Know that, Cost of Equity (R E ) = D 1 / (P 0 +g) Given, D 0 = 2.75 P 0 =59 g = 5.80% = 0.058 D 1 = D 0 (1+g) D 1 = 2.75 (1+0.058) D 1 = 2.75x1.058 D 1 = 2.91 Now, we can calculate the Cost of Equity (R E ) = D 1 / (P 0 +g) = 2.91/ (59+ 0.058) = 0.1073 Therefore, the cost of equity for the company to finance through its own equity is 10.73%. Q. 4 Ans: Calculation of Growth rate of each year Year 1 = ($1.82-$1.71)/$1.71 = 0.064 =6.43% Year 2 = ($1.93- $1.82)/$1.82= 0.060 = 6.04% Year 3 = ($1.99-$1.93)/$1.93 = 0.031= 3.11% Year 4 = ($2.08 -$1.99)/$1.99 = 0.045= 4.52%

Therefore the growth rate for year 1 is 6.43% , year 2 is 6.04%. year 3 is 3.11% and year 4 is 4.52%) respectively. So, the Arithmetic Growth rate = (6.43% + 6.04% + 3.11% + 4.52%)/4 = 5.025% Now, Cost of equity (R E ) = (D 1 /Current stock price) + g (R E ) = ((2.08 (1+0.0525))/$45) + 0.0525 = 9.879% Geometric Growth rate = $2.08 = $1.71 (1+g) 4 G = 5.02% The cost equity using the geometric dividend growth rate is; (R E ) = ((2.08 (1+0.0502))/$45) + 0.0502 = 9.874% Therefore, Cost equity is 9.874% Q. 7. a . Ans: n = 60 PV = -930 (the current price of the bond, which is 93% of the face value) PMT = 35 (7% of $1,000, paid semiannually) FV = 1,000 PV = ($35 / 0.035) * (1 - 1 / (1 + 0.035 / 2) 60 ) + $1,000 / (1 + 0.035 / 2) 60 PV = $866.47

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The yield to maturity, or interest rate at which the bond's price is equal to the present value of its future cash flows, is the pre-tax cost of debt: PV = $930 = ($35 / y) * (1 - 1 / (1 + y / 2)^ 60) + $1,000 / (1 + y / 2) ^60 y = 3.77% So, the pre-tax cost of debt is 3.77% b. after-tax cost of debt is: After-tax cost of debt = Pre-tax cost of debt * (1 - Tax rate) = 3.77% * (1 - 0.35) = 2.45% There for the After-tax cost of debt is 2.45% c. Because it indicates the actual cost of borrowing after deducting the tax advantages of interest payments, the after-tax cost of debt is more pertinent. The corporation can more accurately compare the cost of debt to the cost of equity or other types of funding that might not be tax deductible by using the after-tax cost of debt. Q.9. Ans: a. We know that, WACC= Wd*Kd(1-t) + Wps*Kps + We*Ke WACC = 0.25*7 %*( 1 - 0.35) + 0.05*5% + 0.70*11% WACC = 0.25*4.55% + 0.05*5% + 0.70*11% = 1.1375% + 0.25% + 7.70%

= 9.0875% Therefore, Peacock’s WACC is 9.0875% b. Debt acts as a tax shelter since interest payments are tax deductible. Like debt, preference shares do not have any tax advantages. will inform the president that the company does not use further preferred shares because it is more expensive than debt. Q.18. Ans: a. The decision to borrow the entire amount may not have been wise because it is crucial to maintain a healthy capital structure. The company should use more equity financing than debt financing to maintain an ideal capital structure, according to the target debt-to-equity ratio of 0.60. It is because a company's creditworthiness can be damaged and financial risk increased by relying too heavily on debt funding. It may result in higher debt interest rates and a higher cost of capital. The debt-to-equity ratio, which measures the company's financial leverage, might rise if it relies too heavily on debt financing. High financial leverage can make a company's earnings and cash flows more volatile, hence more susceptible to external influences like economic downturns. b. We know that, Weighted Average Flotation Cost = (Equity Proportion x Equity Flotation Cost) + (Debt Proportion x Debt Flotation Cost) Weighted Average Flotation Cost = (0.4 x 0.07) + (0.6 x 0.03) = 0.048 or 4.8% So, The flotation cost is 4.8%.

c. We know that, Cost of Debt = Amount of Debt / (1 - Flotation Cost) = $14.4 million / (1 - 0.03) = $14.85 million The cost of issuing new equity will be: Cost of Equity = Amount of Equity / (1 - Flotation Cost) = $9.6 million / (1 - 0.07) = $10.32 million Therefore, the total cost will be: $14.85 million + $10.32 million = $25.17 million, Total cost is $25.17 million, which is higher than the $24 million needed for the project. The fact that the entire sum is being raised through debt is irrelevant in this situation because flotation charges affect the cost of debt and boost its effective cost. The actual cost of funding the project for the corporation will therefore be higher than the cost of debt alone. The fees related to issuing debt, known as floatation charges, can affect a corporation's effective cost of debt.

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Reference:

Westerfield, R. W., Roberts, G., Holloway, T., Ross, S. A., Jordan, B. D., & Pandes, J. A. (2019). Fundamentals of Corporate Finance . McGraw-Hill Ryerson.

ASSIGNMENT 7

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