COLLEGE OF BUSINESS, HOSPITALITY AND TOURISM STUDIES

DEPARTMENT OF BANKING & FINANCE

FIN 601: CORPORATE FINANCE
TRIMESTER 2, 2018
TUTORIAL 2: QUESTION

1. Explain the relationship between the cost of capital and the value of the firm.
2. What are marginal costs?
3. Why is the marginal cost of capital more relevant to making investment decisions
than the historic cost of capital?
4. A zero coupon bond has a face value of $100 and 10 years to maturity. Interest
accrues on the bond annually. The net proceeds of the bond are $47.60. Use the
approximate cost of debt equation to determine the before- and after-tax costs of the
zero coupon bond, given the tax rate of 30%.
5. Winter Ltd is planning to issue bonds with 4 years to maturity and a face value of
$100. The coupon rate of the bonds is 6.5% and coupons are paid annually. Winter
expects the net proceeds from each bond issued to be $95. Given the tax rate is 30%,
determine the before- and after-tax cost of debt using the approximate cost of debt
equation.
6. Currently, Aims Ltd can sell 10-year, $100 face value bonds with a 12% pa coupon,
paid semi-annually. The bonds can be sold for $105 each. Flotation costs of $2.50 per
bond will be charged by the underwriter handling the issue. The corporate tax rate is
30 per cent.

(a) Find the net proceeds from the sale of the bond.
(b) Use the approximation formula to estimate the before- and after-tax cost of
debt.

7. KT Ltd is planning the issue of preference shares at an offer price of $80 per share.
Dividend payments of $8 will be made annually and they will be fully franked.
Flotation costs are estimated at 5.5% of offer price. What are the before and after-tax
costs of preference shares for KT, given the tax rate of 30%?

8. GM Co. has $3 million in retained earnings. GM shares have a market value of $9.50
each. Fully franked dividends are paid annually. The next dividend of $1.50 is due in
12 months. New shares could be issued to raise net proceeds of $8.90 per share. GM
has a growth rate of 2.5% per annum and this rate is expected to continue for the
foreseeable future. Given a tax rate of 30%, what are the before- and after-tax costs of
retained earnings

9. The ordinary shares of Fragile Ltd are currently trading at $2.60. A new share issue
would be made at an offer price of $2.50. Issue costs are expected to be 5% of the
proceeds of the issue. The last dividend was 27c and the next dividend is due a year
from now. Dividends are fully franked. The estimated growth rate is 1.5% per annum

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed.,
chapter 7, Australia: Wiley. Page 1
 and this rate is expected to continue. The corporate tax rate is 30%. Calculate the
appropriate before tax costs of retained earnings and a new share issue.

10. The target financing mix for Apple Ltd is 8% preference shares, 32% debt (half bonds
and half leases) and 60% ordinary equity. Apple Ltd does not have retained earnings
available as a source of funds. The before- and after-tax component costs are as
follows:

Calculate the WACC for Apple Ltd under the assumption that:
(a) Fully franked dividends are paid and the company is owned by local resident
shareholders.
(b) Partially franked dividends are paid and the marginal investor in the company
does not live in the local economy.

11. Given a 30% corporate tax rate and the following information for H1N1 Ltd:
 10 000 bonds with a face value of $100, a coupon rate of 12 per cent, an issue
price of $92.30, and 5 years to maturity. Coupons are paid semi-annually. Use the
approximate cost of debt method.
 70 000 11 per cent preference shares with a face value of $2 and net proceeds of
$1.86.
 500 000 ordinary shares with an issue price of $3.00, dividend growth rate 1 per
cent per annum in perpetuity. The last dividend was $0.15 and the next dividend
is due in about 1 year. Flotation costs will be 3.5% of the issue price (assume a
new issue is made).

Required:
 Calculate the cost of each source of finance before and after tax.
 Using the weightings associated with issuing the proposed amount of each
security; calculate the weighted average cost of capital.

THE END

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed.,
chapter 7, Australia: Wiley. Page 2