Cost of debt

Question 1
A company has on issue bonds with the following terms:
 Face value per bond $500 000
 Coupon (paid annually in arrears) 5%
 Current market value per bond $480 000
 Term to maturity 1 year

What is the current yield to maturity of the bonds? Round your answer to three decimal places.

C1  F1
P0 = (1 kd )

kd = C1  F1
P0 
1

Accordingly, 25 000  500 000


kd =
480 000
= 0.094

Answer: 9.4%.

Question 2
A company has on issue bonds with the following terms:
 Total face value $500 000
 Coupon (paid annually in arrears) 7.0%
 Yield to maturity per annum 10.0%
 Term to maturity 3 years

What is the current market price of each bond?

 Cost of equity
Question 3
What is the cost of equity capital for a company with an equity beta of 1.8 assuming the risk-
free rate is 6 per cent per annum and the expected return on the market is 13 per cent per
annum?

ke = rf + [E(rm) − rf ] ße

where: r = risk-free
f = rate;
ß = equity
e = beta;
E( expected return on the
rm market;
) expected market risk
E(rm) – premium.
rf

Solution

k = 0.06 + 1.8 × (0.13 − 0.06)

e
= 0.186

Cost of preference shares

Question 4
CDE Ltd has $10 par value preference shares on issue, which pay an annual dividend of 6 per
cent per annum and which are currently trading at a yield of 8 per cent per annum. What is the
current market price of each preference share?

D
P = p
kp
where: Dp = annual dividend (= dividend rate × par value);
kp = current market yield.

Solution
The market price of each preference share is:

0.06  10.00
P =
0.08

= 7.50

Question 5
BCD Ltd has $10 par value preference shares on issue that pay an annual dividend of 5 per cent
per annum and that are currently trading at $9 each. What is the current cost of the
preference shares to the company?

Solution
The cost of preference shares is:
 kp =

D
p

P
where: Dp = annual dividend (= dividend rate × par value);
P = current market price.

Accordingly,
0.05  10.00
kp =
9.00
= 0.05
Weighted average cost of capital
Question 6
Rank the following financing components in increasing order of their riskiness

Solution
From lowest to highest relative risk, the ranking is:
1. bank debt
2. bonds
3. preference shares
4. ordinary shares

Question 7
You are given the following information on Herrist Ltd:
 equity beta of 1.5
 target debt-to-assets ratio of 30 per cent
 before-tax cost of debt of 10 per cent per annum
 corporate tax rate of 30 per cent.

Assuming the risk-free rate is 6 per cent per annum and a market risk premium is 8 per
cent per annum, what is the company’s after-tax weighted average cost of capital (WACC
Question 8
You are given the following information on National Deliveries Ltd:
 cost of equity per annum 20.0%
 before-tax cost of debt per annum 10.0%
 book value of debt $25 000 000
 book value of equity $50 200 000
 market value of debt $30 000 000
 market value of equity $70 000 000
 corporate tax rate 30%

What is the company’s after-tax WACC?

Question 9
You are given the following information on Worldwide Explorers Ltd:
 cost of equity per annum 18.0%
 before-tax cost of bonds per annum 12.0%
 before-tax cost of bank debt per annum 9.0%
 book value of bonds $7 700 000
 book value of bank debt $5 000 000
 book value of ordinary equity $6 700 000
 market value of bonds $10 000 000
 market value of bank debt $8 000 000
 market value of equity $12 000 000
 corporate tax rate 30%

What is the company’s after-tax WACC?

Question 10
The cost of equity of CLF Ltd is 18 per cent per annum and the market value of its debt and
equity are $50 000 000 and $150 000 000 respectively. The company’s tax rate is 30 per cent
and its after-tax WACC has been estimated at 15 per cent. Based on this information, what is
the company’s before-tax cost of debt?
Present and future values
Question 11
If you invest $50 000 in a savings account paying 6 per cent per annum compounded annually,
what lump sum amount will you have accumulated after five years?

How does your answer change if you invest $50 000 for five years in a savings account
paying 6 per cent per annum where interest is compounded monthly?

Soltion

F = PV0 × (1 + r) n

V
n
F = 50 000 × (1 + 0.06) 5

V
5
= 66 911.28

FV6 = 50 000 × (1 + 0.06 / 12) 5 × 12

0
= 67 442.51

Question 12
You can repay a debt by paying either $20 000 now or $31 000 in five years time. If the interest
rate is 10 per cent per annum, compounded quarterly, should you repay the debt now or at the
end of five years?

PV0 = FVn / (1 + r / m) n×m

Solution

Accordingly,
PV0 = 31 000 / (1 + 0.10 / 4) 5×4

= 18 918.40

Answer: $18 918.

Annuities
Question 13
If you invest $4000 every quarter in a savings account paying 6 per cent per annum
compounded quarterly, what lump sum amount will you have accumulated after seven years?
Question 14
Ten years ago you had borrowed $400 000 from a bank to purchase your first home. The
durationof the loan was for 25 years and you have been paying off the loan in equal monthly
instalmentsof $4212.90 based on an interest rate of 12 per cent per annum compounded
monthly. If you now wish to repay this loan in full, what total amount would you need to pay
the bank?

Question 15
You have just seen the following advertisement at your local bank: ‘Deposit $20 000 today
and receive $2000 per annum forever’. If the first cash flow occurs at the end of year 1, what
is the implied annual interest rate that the bank is offering you?

PV0 = C/r

Accordingl
y,
20 = 2000 / r
000 = 2000 / 20 000
r
= 0.10

Answer:
10%.

Question 16
An investment opportunity offers you $1000 at the end of year 1, which is then expected to
grow at a constant rate of 2 per cent per annum forever. The interest rate appropriate for
valuing such investment opportunities is 10 per cent per annum.

What is the present value of this investment?

PV0 = C1 / (r − g)

PV0 = 1000 / (0.10 − 0.02)

= $12 500

Answers: $12 500

Effective interest rates
Question 17
What is the effective annual interest rate if the nominal (or quoted) rate is 10 per cent per
annum with interest rate compounded quarterly?

How does your answer change if the interest were compounded monthly or daily?

(1 + re) = (1 + r / m) m

Solution

re = (1 + 0.10 / 4) 4 – 1
= 0.1038

The effective interest rate using monthly compounding is:

re = (1 + 0.10 / 12)12 – 1
= 0.1047

Nominal and real interest rates

Question 18
Assume that the current nominal interest rate is 10 per cent per annum. If the inflation rate is
expected to be 7 per cent per annum, what real interest rate is implied by this information?

(1 + r) = (1 + a) (1 +  )

That is: r = (1 + a) (1 +  ) – 1

where: r = nominal interest rate;

a = real interest rate;
 = expected inflation
rate.

Solution

(1 + = (1 + r) / (1 +  )
a)
a = (1 + r) / (1 +  ) – 1
= (1 + 0.10) / (1 + 0.07)
= −1
0.028

Assume that the real interest rate does not change and the expected inflation rate drops
from 7 per cent to 4 per cent. What is the new nominal interest rate based on this
information?

r = (1 + a) (1 +  ) – 1
= (1 + 0.028) (1 + 0.04) – 1
= 0.069

Answers: 2.8% and 6.9%.

Question 18a
A company is considering an investment in a project costing $140 000. The estimated
nominal net cash flows for the project are as follows:

Year Net cash flow

1 $48 000
2 $96 000
3 $64 000

The company’s real discount rate is 12 per cent per annum. If the expected inflation
rate is 5 per cent per annum over the next three years, what is the NPV of the project?

(1 + r ) = ( 1 + a) (1 +  )

Then use the nominal discount rate to discount the nominal cash flows to obtain the NPV.
NPV of single and multiple project
Question 19
A project is expected to yield the following net after-tax cash flows:

Year 0 1 2 3 4
Cash flow −$120 000 $30 000 $88 000 $60 000 $24 000

If the required rate of return on this project is 10 per cent per annum, what is the net
present value (NPV) of this project?

What decision should the company make and why?

The NPV is obtained as

follows:
n

NPV =
 C / 1 k t I
t
t1 0

Solution
This problem requires discounting the project’s cash flows to determine its NPV. If the
project’s NPV is positive, the project is acceptable because it adds value to the company.

NP = 30 000 / 1.10 + 88 000 / 1.102 + 60 000 / 1.103 + 24 000 / 1.104 −

V 120 000
= 27 272.73 + 72 727.27 + 45 078.89 + 16 392.32 − 120 000
= 41 471.21
IRR
Question 20
FGH Ltd is considering two projects that are expected to yield the following net after-
tax cash flows:

Year 0 1 2 3 4
Project A −$200 000 $216 000 — — —
Project B −$250 000 — — — $366 025

Calculate the internal rate of return (IRR) of each project. =

The IRR is the discount rate obtained in the following calculation:

n

NPV = 0= / 1 IRR t  I

Ct t 1 0

Project A’s IRR:

0 = 216 000 / (1 + IRRA) − 200
000
1 + IRRA = 216 000 / 200 000
IRRA = 216 000 / 200 000 – 1
= 0.08

Project B’s IRR:

0 = −250 000 + 366 025 / (1 +
IRRB)4
(1 + IRRB)4 = 366 025 / 250 000
IRRB = (366 025 / 250 000)1/4 – 1
= 0.10

Answer: The projects’ IRRs are 8.0% and 10.0%, respectively.

if the required rate of return were 7 per cent, the company should accept both projects as the
IRRs are greater than the required rate of return, implying that both projects are positive NPV
projects.

Question 21
You have evaluated two mutually exclusive projects, which have the following IRR and
NPV. The NPV of both projects has been calculated using the same discount rate.

Project A Project B
IRR 10% 15%
NPV $1 300 000 $1 300 000

Based on this information, does the discount rate lie below 10 per cent, between 10 per cent
and 15 per cent or above 15 per cent?

Solution
In this example, both projects have a positive NPV, so the discount rate must be lower than
the IRR of each project. Thus, the discount rate must be less than 10 per cent.

Answer: The IRR lies below 10 per cent

Question 22
You have evaluated three mutually exclusive projects of equal lives, and found the following
IRRs and NPVs.
Project A Project B Project C
IRR 13% 12% 11%
NPV $200 000 $110 000 $220 000

Solution
Specifically, if you use the IRR method, the decision would be ‘accept project A’ because it
has the highest IRR. Alternatively, if you use the NPV method, the decision would be ‘accept
Project C’ because it has the highest NPV. These differences can arise due to differences in
scale of projects, or differences in timing and magnitude of future expected cash flows.

Since the NPV rule is more robust, because it directly measures the additional shareholder
wealth created by a project, it is the preferred criterion. in Module 3. So, the project with
the highest positive NPV, that is Project C, should be selected.

Answer: Project C.

Question 23
A company has to choose between two alternative machines, A and B, which perform the same
function and have the same operating revenues but which have lives of two and three years,
respectively. The initial investment outlays and net annual operating costs are as follows:

Machine A Machine
B
Initial investment $30 000 $42 000
Net operating cost $6 000 $5 000
Years 2 3

Solution
Machine A Machine B
End of year (Repeated twice) (Repeated once)
0 –30 000 –42 000
1 –6 000 –5 000
2 –30 000 –6 000 –5 000
3 –6 000 –42 000 –5 000
4 –30 000 –6 000 –5 000
5 –6 000 –5 000
6 –6 000 –5 000

Evaluating cash flows over a six-year period, at a 10 per cent discount rate, the NPVs are:

Project A’s = –30 000 – 6000 / (1.10)1 – 36 000 / (1.10)2 – 6000 /

NPV (1.10)3
– 36 000 / (1.10)4 – 6000 / (1.10)5 – 6000 / (1.10)6
= –$101 415

Project B’s = –42 000 – 5000 / (1.10)1 – 5000 / (1.10)2 – 47 000 /

NPV (1.10)3
– 5000 / (1.10)4 – 5000 / (1.10)5 – 5000 / (1.10)6
= –$95 332
EAA
Question 24
A company is considering the following mutually exclusive projects, which have constant
expected annual cash flows over unequal lives, as follows:

Project A Project B Project C

Initial investment $110 000 $90 000 $80 000
Net cash flow $39 000 $49 000 $42 000
Life (years) 17 5 10

The company’s cost of capital is 12 per cent per annum.

Solution

Answer: Project C
Question 25
Which of the following items should be specifically taken into account in cash flow
estimation for project evaluation?
 working capital
 depreciation (x)
 amortization (x)
 head office salaries (x)

Overview
In project evaluation, only the cash flows that change as a direct result of the decision to
undertake the project are taken into account. Examples of these cash flows include:

 Working capital—Additional inventory, debtors and cash required to support a project

should be included. Normally, these amounts are recovered at the termination of the
project, and are not subject to depreciation.

 Opportunity costs—The current market value of existing assets should be included as part
of the investment in the proposed project. For example, the market value of land to be
used, which the company already owns, is a cost to the project, even though the cost was
incurred in the past.

 Side effects—Adding a new product may divert sales from the company’s existing
products. In such a case, not all revenues from the new project are incremental.

 Overhead allocations—A project should only carry overheads that are truly incremental.
Allocations of costs that would be incurred whether the project was undertaken or not
should be avoided.

 Tax shields—An important component of a project’s cash flow is the tax shield that it
generates. Any expense that is deductible for tax purposes has a tax effect by reducing
the tax payable. This includes depreciation, which, while not a cash flow itself, has a
cash flow impact because of its associated tax shield. That is, only the depreciation tax
shield is included in the incremental cash flows from a project. It should be noted that
tax shields are only available to tax paying companies.

Note that costs that are incurred in the past (e.g. R&D expenditures) are sunk costs as they
cannot be recovered and should have no bearing on whether to accept or reject a proposed
project.
1. Cost of debt P.1
2. Cost of Equity P.2
3. Cost of preference shares P.2
4. WACC P.3-4
5. Present & Future value P.5-6
6. Effective interest rate P.7
7. Nominal & real interest Rate & Q18a case P.7-8
8. NPV P.9
9. IRR P.10
10. EAA P.12