For in-depth coverage and reading please refer to Chapters 17 (page 318) of the 2013 ACCA

F9 Financial Management Emile Woolf Study Text

Cost of
Capital
WACC

Project Specific Cost of Capital

1|Page
WACC

QUESTION 7 – MAF503/JUN 2019 – Example in the slides

Milea Sdn Bhd (Milea) is going to issue new bonds and common stocks to raise funds needed
for their latest projects amounting to RM3,000,000. The company’s debt and equity as at 30
June 2019 are as follows:

RM
8% Bond at par 2,800,000
Preference shares 2,000,000
Common stock at par 1,200,000
Retained Earnings 1,000,000
7,000,000

The market value of the 8% bond (par value RM1,000) is RM920. After the maturity period of 5
years, the bond will be redeemed at RM1,040. Floatation cost on the new bond is 4% of the
market value.

7% preference shares with a par value of RM100 can be sold at 2% discount. An additional fee
of 3% of the par value must be paid.

The common stocks (par value RM1.00) are currently selling at RM2.00. Milea proposes to pay
next year’s dividend of RM0.15 per share and the dividend is assumed to grow at a constant
rate of 5% and the floatation cost on the issuance of common stock is 10% of the market price.
All retained earnings available as at 30 June 2019 is going to be used for re-investment
purposes. The corporate tax rate is 24%.

Required:

A. i. Calculate the individual after-tax cost of:

a. new debt
b. preferred shares
c. retained earnings
d. new common stocks

ii. Calculate the number of bonds to be issued if the company plans to undertake
the above projects.

B. Determine the firm’s weighted average cost of capital if the projects are undertaken.

C. “A firm needs to determine its cost of capital”

Explain the above statement.

2|Page
QUESTION 6 – MAF503/JAN 2018

PetCo Chemical Bhd (PetCo) is raising fund for the new plant located in Pengerang, Johor. The
project cost is estimated to be RM50 million. The shortfall in funding allocation of the new plant
is likely to be funded from both externally and internally generated fund. Currently, PetCo has
internal funding amounted to RM15 million retained earnings available for re-investment.

PetCo is planning to obtain the external fund through a mixture of issuing bonds, preferred
stocks and common shares. PetCo will issue new bonds at a discount of 3% from its par value.
The annual coupon rate of the bond is 10% per annum. The bonds will mature in 10 years and
to be redeemed at par value of RM1,200. The issuance of new bonds will incur a floatation cost
of RM64.

The 12% preferred stocks can be issued at a premium of 20% from its market value. The
dividend is paid based on the par value. The par value of the preferred stock is RM100 and the
issuing cost is RM4. The current share price of the preferred stock is RM120.

At present, the common shares are selling at RM10.80 per share. The underwriting cost for
issuing the new shares is 5% based on its current value per share. The dividend paid last year
was RM1.25 per share and is expected to grow at a constant rate of 3% a year.

PetCo’s optimal capital structure is as follows:

RM
Common stock 100,000,000
Retained earnings 16,900,000
Preferred stock 13,000,000
Bonds 37,100,000
167,000,000

Note: The company’s tax rate is 24%.

Required:

a. Calculate the component cost of capital for:

i. New debt (after tax)

ii. New preferred stock
iii. Internal equity
iv. New common stock

b. Determine the maximum amount of capital expenditure that the company can undertake
without issuing new common stock.

c. Advise the management of PetCo, the appropriate weighted average cost of capital that
the company would incur if the management decided to set up the new plant.

3|Page
QUESTION 5 – MAF503/DEC 2018

In the year 2019, Rail Transport Berhad (RTB) has secured a sub-tender of electrical drawing
layout from the main contractor “Electrical Speed Rail Project” with the Government of Brunei at
cost of RM13 million. Currently, the optimal capital structure of RTB in raising its financing
capital budgeting projects based on the following debt and equity as at 31 December 2018:

RM
4% Debentures 8,750,000
6% Preferred shares 5,250,000
Ordinary shares at par value RM1.00 17,500,000
Retained earnings 3,500,000
35,000,000

The board of directors RTB agreed to finance the project from the mixture of external funding as
follows:

 Issue 4% debenture at a market value of RM950. Floatation cost on the new debenture
is 10% of the market value. On the expiration of maturity period of 10 years, the
debenture will be redeemed at RM1,050. The par value is RM1,000.

 Issue 6% preferred shares, which currently is selling at RM130. The nominal value of
preferred shares is RM110 with a dividend paid based on nominal value. The issuance
cost is 2% of the market value.

 Issue ordinary shares at market price RM8.00 per share. The floatation cost associated
with the issuance is 5% of the market price. Total dividend paid last year by RTB to its
ordinary shareholders is RM1,750,000 on the outstanding number of ordinary shares
issued as per optimal capital structure. RTB assumed the dividend to grow at a constant
rate of 5% per annum.

All retained earnings available as at 31 December 2018 are used for re-investment purposes.
The corporate tax rate is 24%.

Required:
a. Calculate the after tax cost of:

i. Debt
ii. Preference shares
iii. Internal equity
iv. New ordinary shares

b. Determine the number of units’ ordinary shares to be issued (subject to full utilization of
retained earnings) if RTB undertake the above projects.

c. Suggest the appropriate weighted average cost of capital if Rail Transport Berhad
undertakes the sub-tender of electrical drawing for “Electrical Speed Rail Project”.

4|Page
QUESTION 4 – MAF503/JULY 2017

Dynamic Construction Sdn Bhd secured a tender value of RM12 million to rebuild an indoor
sports arena for the 2017 Sea Games. Its’ optimal capital structure is as follows:

RM
9% Redeemable debentures 8,000,000
7% Preferred stocks 2,500,000
Common stocks 12,000,000
Retained earnings 7,500,000
30,000,000

After consultation with investment banker, Dynamic Construction expects to be able to finance
any new projects using the following resources:

 To issue new corporate redeemable debentures at a premium of 15% from its par value
RM1,000 with a redemption period of 10 years at par. The flotation costs associated with
the issuance is 4% of the issued value.

 To issue preferred stocks at a discount of 5% from its market value. The issuing cost
related to the issue is 2% of the issued price. The value of preferred stock is RM110
and RM120 at par and market price respectively.

 To issue common stocks at market price of RM15.50 per share. The underwriting cost to
be paid is 6% based on its market value. Dynamic Construction is expected to pay a
dividend of RM1.254 per share next year compared to RM1.20 per share last year. The
dividend are expected to grow at a constant rate of 4.5% per annum in the foreseeable
future.

Dynamic Construction also has internal funding amounted to RM5.5 million retained earnings
available for re-investment. Assuming that the company’s tax rate is 24%.

Required:

a. Calculate the after tax cost of:

i. Debt
ii. Preference shares
iii. Internal equity
iv. New ordinary shares

b. Determine the number of units of common stocks to be issued in pursuant to the

financing of the above project should Dynamic Construction wishes to utilize the retained
earnings for re-investment.

c. Discuss the impact of the following risks to the firm’s cost of capital:

i. Business risk
ii. Financial risk

5|Page
QUESTION 3 – MAF503/JUN 2016

Dortmund City Berhad (Dortmund) decides to invest RM10 million in a new project known as
“Bandar Malaysia”. Dortmund plans to maintain its’ optimal capital structure as follows:

RM
5% Corporate Debt 5,000,000
7% Preferred Stock 2,000,000
Common Stocks at par 10,000,000
Retained Earnings 3,000,000
20,000,000

The board of director has agreed with the proposals to issue the following bond and equity to
finance the project:

1. Issue a corporate bonds at a premium of 10% from the par value of RM1,000. The
floatation cost is 5% of the issued value. The corporate bonds can be redeemed at a
maturity period of 10 years at par value.

2. Issue preference shares at a 5% discount. The flotation cost on new preference shares
is charged at 3% of the issuing price. The nominal value of preference share is RM100.

3. Issue new common shares which are currently selling at RM10 per share. The flotation
costs of 5% will have to be incurred on the market value. Dortmund will pay a dividend of
RM2.00 per share next year and dividends are expected to grow at a constant rate of
5% per annum for the foreseeable future.

4. Dortmund has allocated RM2,000,000 of the retained earnings for re-investment

purposes.

The corporate tax rate is 25%.

Required:

a. Calculate the after tax cost of:

i. Debt
ii. Preference shares
iii. Internal equity
iv. New ordinary shares

b. Based on the maximum amount of capital expenditure and full utilization of its retained
earnings, explain whether the company has sufficient capital to invest in the project.

c. Calculate the weighted average cost of capital if the company wishes to undertake the
investment in “Bandar Malaysia”.

6|Page
QUESTION 2 – MAF503/DEC 2016

Goldman Telco Sdn Bhd (Goldman) is considering undertaking a new satellite project tower
next year. The project cost is estimated to be RM10 million. The optimal capital structure is as
follows:

Capital Structure Weight of Financing (%)

10% Irredeemable Debentures 30%
4% Preference Share 10%
Common Equity 60%

Goldman plans to issue the following debentures and shares to finance the project cost:

1. Issue 10% irredeemable debenture with no maturity period at RM1,100 par value. The
market value is RM1,500. The floatation cost is estimated to be 5% of the market value.

2. Issue 4% preference shares at market price of RM105. The par value and net market
price of the preference shares is RM100 and RM95 respectively. Goldman paid RM4.00
dividend per share.

3. Issue common shares which currently selling at RM45 per share. Goldman proposes to
pay next year’s dividend RM4.50 after incorporating growth rate. The rate is expected to
grow at a constant rate of 8% per annum. However, the floatation cost for the issuing of
new common shares will depend on the value of common shares issued. If the
company decided to issue new common shares valued below RM4,500,000, the
floatation cost is 15% of market price but the cost would rise to 20% if the value exceed
RM4,500,000.

Currently, the retained earnings available for re-investment is RM1,500,000 for next year.
Company tax rate is 25%.

Required:

a. Calculate the individual after tax cost of capital of the following:

i. Cost of debt
ii. Cost of preferred share
iii. Cost of internal common equity
iv. Cost of external common equity if the total value of new common shares issue is
RM5,000,000

b. Calculate the maximum capital expenditure if Goldman wishes to utilize the capital from
internal fund.

c. Analyse the marginal cost of capital if Goldman intends to undertake the project.

7|Page
QUESTION 1 – MAF503/JUN 2015 – Solution Provided

Sun Sdn Bhd is considering to invest in a new project costing RM4,000,000. The current capital
structure of the company which is considered optimal is as follows:

RM
Debt 10,000,000
Ordinary shares 6,000,000
6% Preference shares 4,000,000
Retained earnings 3,000,000
23,000,000

Currently, the company has 1,000,000 ordinary shares outstanding at RM11.25 per share. Next
year’s dividend is expected to be RM1.00 per share. Subsequently, the company estimates that
the dividend will grow at 5% per year. The floatation costs for the new shares would be RM0.20
per share.

The 6% Preference shares nominal value worth at RM100 per share. In order to ensure the
preference shares are fully taken up, it is issued at 10% discount to the nominal value and
involve floatation cost of RM0.25 per share.

The debt has RM1,000 par value bonds which can be issued at 5% discount of par value with
10 years left to maturity. The annual coupons are paid at a coupon rate of 9%. Floatation costs
for the new bonds would be equal to 2% of the par value. The bond will be redeemed at 20%
premium of the par value.

Only 50% of the retained earnings will be allocated for this project. Corporate tax rate is 25%.

Required:

a. Calculate the individual cost of capital for the followings:

i. Debt (after tax)

ii. Preference shares
iii. Retained earnings
iv. New ordinary shares.

b. Determine the maximum capital expenditure that the company can undertake without
issuing new ordinary shares.

c. Compute the company’s weighted average cost of capital if the project is undertaken.

d. Briefly explain the importance of having optimal capital structure.

8|Page
SOLUTION 1 – MAF503/JUN 2015

a) i. Cost of debt
NP = (1000x0.95) – 2% (1000)
= 950-20 = 930

Year Cash Flows PVIFA/PVIF@9%√ PV

1-10 90 6.4177 577.59
10 1200 0.4224 506.88
1084.47
NP 930
NPV 154.47

Year Cash Flows PVIFA/PVIF@12% PV

1-10 90 5.6502 508.51
10 1200 0.322 386.40
894.91
NP 930
NPV -35.09

Kd before tax = 9% + ( 154.47/154.47-(-35.09) ) x 3% = 11.44%

Kd after tax = 11.44% ( 1-0.25) = 8.58%

ii. Cost of Preference shares

6% x 100/ ( 90-0.25) x 100

= 6/89.75 x 100 = 6.68%

iii Cosf of ordinary shares: RM1/RM11.25 + 5% = 13.88%

iv Cost of new ordinary shares: RM 1/(11.25-0.20) + 5% = 14.05

b Cost of maximum capital expenditure

= 1,500,000/ 0.39 = RM3,846,153.

Since the cost of project is RM4,000,000, the RM1,500,000 retained earnings is no longer
sufficient to support the financing requirement above RM3,846,153 to maintain 39% equity
portion, therefore the company must issue new shares to finance the project.
c.
Capital structure Weight Ind COC COC
Kd 0.43√ 8.58%√ 3.69%√
Kp 0.18√ 6.68%√ 1.20%√
Knc 0.39√ 14.05%√√ 5.48%
10.37%√

9|Page
d. It represents a capital structure that can minimize its overall cost of capital therefore it
will maximize the value of the firm√ and shareholders’ wealth.

Project Specific Discount Rate - Illustration 1

Example 1 – Q & A in Slides

Company A intends to undertake a project in an unrelated industry.

The following details are relevant:

Item Company A Proxy Company

Equity Beta (βe) 1.2 1.4

Value of Equity 1000 800

Value of Debt 400 500

The risk free rate is 4%. The average return on the market is 12%.
Calculate a project specific discount rate. Ignore Tax

Project Specific Discount Rate - Illustration 2

Example 2 – Q & A in Slides

Company A intends to undertake a project in an unrelated industry.

The following details are relevant:

Item Company A Proxy Company

Equity Beta (βe) 1.1 1.3

Value of Equity 1200 900

Value of Debt 500 450

The risk free rate is 4%.

The average return on the market is
12%. The tax rate is 30%.
Calculate a project specific discount rate.

10 | P a g e
 Short Form Questions
1. What are the two types of risk included in a company’s equity Beta?

2. When do we use the WACC as a discount rate?

3. What is capital structure?

4. What are the steps to calculate a project specific discount rate?

Test Your Knowledge

Multiple Choice Questions

1. Company Alpha is financed with $1,000 of equity and $400 of debt and intends to
undertake a project in an unrelated industry. They have identified Horizon Co. as a
company in the new industry with $700 of equity and $300 of debt. Alpha Co. has a
Beta of 1.3 whereas Horizon Co. has a Beta of 1.2. The risk free rate is 4% and the
average return on the market is 12%. The tax rate is 30%.

Which of the following would be the project specific discount rate for Alpha Co.
when entering the new industry?

A. 12.34% B. 10.25% C. 11.12% D. 13.42%

2. Company Alpha is financed with 60% equity and 40% debt and intends to undertake a
project in an unrelated industry. They have identified Horizon Co. as a company in the
new industry with 75% equity and 25% debt. Alpha Co. has a Beta of 1.1 whereas Horizon
Co. has a Beta of 1.4. The risk free rate is 6% and the average return on the market is
14%. The tax rate is 30%.

Which of the following would be the project specific discount rate for Alpha Co.
when entering the new industry?

A. 19.38% B. 18.00% C. 17.20% D. 16.32%

3. Company Alpha is financed with debt/equity of 1/4 and intends to undertake a project in
an unrelated industry. They have identified Horizon Co. as a company in the new
industry with debt/equity 1/3. Alpha Co. has a Beta of 1.05 whereas Horizon Co. has a
Beta of 1.24. The risk free rate is 6% and the average return on the market is 14%. The
tax rate is 30%.

Which of the following would be the project specific discount rate for Alpha Co.

11 | P a g e
 when entering the new industry?

A. 16.23% B. 15.49% C. 17.26% D. 18.28%

4. Our business has a Beta of 1.2, debt with a market value of 100 and equity with a market
value of 400. If the proxy has a Beta of 1.4, debt with a market value of 100 and equity with
a market value of 200 calculate a project specific discount rate. The risk free rate is 4%
and the average market risk premium is 7%. Ignore tax.

Key answer: Βa = 0.93 βe = 1.163 Ke = 12.14%

12 | P a g e