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<p>1 Burse Co wishes to calculate its weighted average cost of capital and the following information relates to the company<br/>at the current time:<br/>Number of ordinary shares 20 million<br/>Book value of 7% convertible debt $29 million<br/>Book value of 8% bank loan $2 million<br/>Market price of ordinary shares $5·50 per share<br/>Market value of convertible debt $107·11 per $100 bond<br/>Equity beta of Burse Co 1·2<br/>Risk-free rate of return 4·7%<br/>Equity risk premium 6·5%<br/>Rate of taxation 30%<br/>Burse Co expects share prices to rise in the future at an average rate of 6% per year. The convertible debt can be<br/>redeemed at par in eight years’ time, or converted in six years’ time into 15 shares of Burse Co per $100 bond.<br/>Required:<br/>(a) Calculate the market value weighted average cost of capital of Burse Co. State clearly any assumptions that<br/>you make. (12 marks)<br/>(b) Discuss the circumstances under which the weighted average cost of capital can be used in investment<br/>appraisal. (6 marks)<br/>(c) Discuss whether the dividend growth model or the capital asset pricing model offers the better estimate of<br/>the cost of equity of a company. (7 marks)<br/>(25 marks)</p><p></p><p>1 (a) Calculation of weighted average cost of capital (WACC)<br/>Cost of equity<br/>Cost of equity using capital asset pricing model = 4·7 + (1·2 x 6·5) = 12·5%<br/>Cost of convertible debt<br/>Annual after-tax interest payment = 7 x (1 – 0·3) = $4·90 per bond<br/>Share price in six years’ time = 5·50 x 1·066 = $7·80<br/>Conversion value = 7·80 x 15 = $117·00 per bond<br/>Conversion appears likely, since the conversion value is much greater than par value.<br/>The future cash flows to be discounted are therefore six years of after-tax interest payments and the conversion value received<br/>in year 6:<br/>Year Cash flow $ 10% DF PV ($) 5% DF PV ($)<br/>0 market value (107·11) 1·000 (107·11) 1·000 (107·11)<br/>1–6 interest 4·9 4·355 21·34 5·076 24·87<br/>6 conversion 117·00 0·564 66·00 0·746 87·28<br/>––––––– ––––––––<br/>(19·77) 5·04<br/>––––––– ––––––––<br/>Using linear interpolation, after-tax cost of debt = 5 + [(5 x 5·04)/(5·04 + 19·77)] = 6·0%.<br/>(Note that other after-tax costs of debt will arise if different discount rates are used in the linear interpolation calculation.)<br/>We can confirm that conversion is likely and implied by the current market price of $107·11 by noting that the floor value of<br/>the convertible debt at an after-tax cost of debt of 6% is $93·13 (4·9 x 6·210 + 100 x 0·627).<br/>Cost of bank loan<br/>After-tax interest rate = 8 x (1 – 0·3) = 5·6%<br/>This can be used as the cost of debt for the bank loan.<br/>An alternative would be to use the after-tax cost of debt of ordinary (e.g. not convertible) traded debt, but that is not available<br/>here.<br/>Market values<br/>Market value of equity = 20m x 5·50 = $110 million<br/>Market value of convertible debt = 29m x 107·11/100 = $31·06 million<br/>Book value of bank loan = $2m<br/>Total market value = 110 + 31·06 + 2 = $143·06 million<br/>WACC = [(12·5 x 110) + (6·0 x 31·06) + (5·6 x 2)]/143·06 = 11·0%<br/>(b) The weighted average cost of capital (WACC) can be used as a discount rate in investment appraisal provided that the risks<br/>of the investment project being evaluated are similar to the current risks of the investing company. The WACC would then<br/>reflect these risks and represent the average return required as compensation for these risks.<br/>WACC can be used in investment appraisal provided that the business risk of the proposed investment is similar to the<br/>business risk of existing operations. Essentially this means that WACC can be used to evaluate an expansion of existing<br/>business. If the business risk of the investment project is different from the business risk of existing operations, a projectspecific<br/>discount rate that reflects the business risk of the investment project should be considered. The capital asset pricing<br/>model (CAPM) can be used to derive such a project-specific discount rate.<br/>WACC can be used in investment appraisal provided that the financial risk of the proposed investment is similar to the<br/>financial risk of existing operations. This means that financing for the project should be raised in proportions that broadly<br/>preserve the capital structure of the investing company. If this is not the case, an investment appraisal method called adjusted<br/>present value (APV) should be used. Alternatively, the CAPM-derived project-specific cost of capital can be adjusted to reflect<br/>the financial risk of the project financing.<br/>A third constraint on using WACC in investment appraisal is that the proposed investment should be small in comparison with<br/>the size of the company. If this were not the case, the scale of the investment project could cause a change to occur in the<br/>perceived risk of the investing company, making the existing WACC an inappropriate discount rate.<br/>(c) The dividend growth model has several difficulties attendant on its use as a way of estimating the cost of equity. For example,<br/>the model assumes that the future dividend growth rate is constant in perpetuity, an assumption that is not supported by the<br/>way that dividends change in practice. Each dividend paid by a company is the result of a dividend decision by managers,<br/>who will consider, but not be bound by, the dividends paid in previous periods. Estimating the future dividend growth rate is<br/>also very difficult. Historical dividend trends are usually analysed and on the somewhat risky assumption that the future will<br/>repeat the past, the historic dividend growth rate is used as a substitute for the future dividend growth rate. The model also<br/>assumes that business risk, and hence business operations and the cost of equity, are constant in future periods, but reality<br/>shows us that companies, their business operations and their economic environment are subject to constant change. Perhaps<br/>the one certain thing about the future is its uncertainty.</p><p>It is sometimes said that the dividend growth model does not consider risk, but risk is implicit in the share price used by the<br/>model to calculate the cost of equity. A moment’s thought will indicate that share prices fall as risk increases, indicating that<br/>increasing risk will lead to an increasing cost of equity. What is certainly true is that the dividend growth model does not<br/>consider risk explicitly in the same way as the capital asset pricing model (CAPM). Here, all investors are assumed to hold<br/>diversified portfolios and as a result only seek compensation (return) for the systematic risk of an investment. The CAPM<br/>represent the required rate of return (i.e. the cost of equity) as the sum of the risk-free rate of return and a risk premium<br/>reflecting the systematic risk of an individual company relative to the systematic risk of the stock market as a whole. This risk<br/>premium is the product of the company’s equity beta and the equity risk premium. The CAPM therefore tells us what the cost<br/>of equity should be, given an individual company’s level of systematic risk.<br/>The individual components of the CAPM (the risk-free rate of return, the equity risk premium and the equity beta) are found<br/>by empirical research and so the CAPM gives rise to a much smaller degree of uncertainty than that attached to the future<br/>dividend growth rate in the dividend growth model. For this reason, it is usually suggested that the CAPM offers a better<br/>estimate of the cost of equity than the dividend growth model.</p> thx xie 3Q我想知道答案
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