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FMA 101 Topic 7 : The Cost of Capital Assignment Answers
FMA 101 Topic 7 LEARNING OUTCOMES
After completing this topic, you should be able to:
- Present an overview of the cost of capital from which you can identify and list the key assumptions, and explain or discuss the cost of capital, the key assumptions, the target capital structure and the specific sources of capital and their costs associated with the capital structure of a business entity.
- Calculate the cost of long-term debt, preference shares, ordinary shares, retained earnings and new issues of ordinary shares.
- Explain and calculate the weighted average cost of capital (WACC) and discuss alternative weighting schemes that can be used to calculate the WACC
- Explain and calculate the weighted marginal cost of capital (WMCC) and break points at which the cost of one of the financing components starts to rise.
- Explain the purpose of and prepare an investment opportunity schedule (IOS) to make financing investment decisions.
- Demonstrate how the WMCC and IOS can be jointly applied to make financing and investment decisions.
READING FMA 101 Topic 7
Before continuing with this topic, please read the following:
- Gitman et al. (2015: Chapter 9)
Please make sure that you also read this study guide carefully as it contains additional information that is not in the prescribed textbook.
The key concepts that you must focus on are:
- business risk and financial risk
- the capital structure and target capital structure
- sources of capital
AN OVERVIEW OF THE FMA 101 COST OF CAPITAL
The cost of capital is a critical determinant of the value of a business entity.
The cost of capital is the minimum return an entity must earn on any investment project in order to maintain its market value and consider an investment to be viable and acceptable.
From the perspective of providers of capital, it is the rate of return required by them for them to be prepared to make available finance to business entities.
Any return received from an investment that is higher than the cost of capital will increase the value of an entity, while a return lower than the cost of capital will decrease the value of the entity.
In order to consider the effect of the cost of capital on business decisions, it is assumed that both the business risk and financial risk of the entity remain unchanged and, where applicable, the after-tax cost of finance is used to make investment decisions.
Understanding how to calculate the cost of capital is essential knowledge for financial managers. When considering alternative sources of funding to use for the financing of capital expenditure projects, managers will endeavour to make use of those sources of funds of which the cost of funding is the lowest.
The cost of every funding source, such as long-term loans or shares, must, therefore, be determined and the most cost-effective option selected. Choosing a funding option with a high cost of capital through error will eventually seriously affect the return on investment of a project.
Beacuse the different sources of finance that an entity can utilise to finance its investments each has a different cost of capital, an entity will endeavour to configure its capital structure in such a way that the overall cost of capital, the average cost of all the sources utilised combined, is as low as possible. The capital structure that enables an entity to minimise its overall cost of capital is known as the target capital structure.
It is also very important that you can identify and discuss the different sources of long-term funds available to organisations. Refer to the very useful summary of these sources provided in the prescribed textbook.
THE COST OF LONG-TERM DEBT
The key concepts that you must focus on are:
- net proceeds obtained from long-term debt
- the before-tax cost of debt
- the after-tax cost of debt
You must be able to explain and discuss the meaning of the cost of long-term debt with reference to:
- net proceeds
- the before-tax cost of debt
- the after-tax cost of debtYou need to take note of the different ways in which the before-tax cost of debt can be obtained. The three methods explained are the quotation method, calculation or approximation.
THE BEFORE-COST OF DEBT – USING COST QUOTATIONS
Two methods of quotations are distinguished.
If the net proceeds (the selling price less all issuing costs) are equal to the par value (face value of the debt, then the before-tax cost of debt is equal to the coupon interest rate of the debt.
If, for example, a 12% debt is issued with a selling price = R1 100 and the total issuing costs = R100, then the net proceeds from issuing the debt equals R1 000 (R1 100 – R100). If the par value of this debt is also equal to R1 000, then the before-tax cost of the debt will be 12%.
An alternative method is known as the yield-to-maturity (YTM) method. The yield to maturity of a similar debt instrument is used as an approximation of the before- tax cost of the debt instrument used to finance the debt.
For example, if an entity issues a bond and the yield-to-maturity for a similar bond is 10%, then the before-tax cost of the bond issued can be estimated to be 10% as well.
A third method to estimate the before-tax cost of debt is to calculate the internal rate of return (IRR) of the cash flows from the debt. The IRR is considered to be the yield to maturity.
The calculation of the IRR is explained in Topic 8.
THE AFTER-TAX COST OF DEBT
The after-tax cost of debt is calculated by using the following formula:
After-tax cost of debt = Before-cost of debt × (1 – tax rate)
You must also be able to calculate the after-tax cost of long-term debt using the information provided.
Note that this section uses the cost of long-term bonds in the examples. This section also applies to the calculation of the cost of debentures and other types of long-term loans.
A debenture is a type of long-term loan whereby the borrower is obliged to pay to the debenture holder a specific rate of interest per period calculated on the debenture amount. After the expiry of the loan period, the borrower must repay the capital amount of the debenture.
A long-term loan is similar to a debenture and the after-tax cost of the debt is calculated using the formula provided.
THE COST OF PREFERENCE SHARES
You must be able to explain what preference shares are and how they differ from ordinary shares.
You must also be able to explain what preference share “dividends” are and how they are generally stated.
You need to take note of the following:
Preference shares normally do not have a maturity date (they are irredeemable) and, therefore, the cost of preference shares is calculated by applying the formula for a perpetuity (refer to Topic 4 – Time value of money).
You must also be able to calculate the cost of preference shares from the information provided.
When dividends are declared, holders of preference shares are entitled to receiving dividends before any dividends are paid to ordinary shareholders, hence the name preference shares. These shareholders receive preference over ordinary shareholders.
Preference shares have a dividend percentage value or rand value stated, for example “8% preference shares” or “R4 preference shares”.
The cost of preference shares can consequently be higher than that of ordinary shares.
THE COST OF ORDINARY SHARES
You must be able to explain how the cost of ordinary shares is calculated and calculate the cost of ordinary shares using the following techniques:
- The Gordon share valuation models
The different techniques used to calculate the value of ordinary shares are explained and demonstrated in the chapter dealing with share valuations and Topic 5 of this guide.
You must also pay attention to the cost of retained earnings. Retained earnings represent that portion of distributable profits that an organisation holds back instead of distributing it to its shareholders in the form of dividends. The cost of retained earnings, therefore, is the same as the cost of ordinary shares.
Retained earnings are a form of loan from the shareholders of the organisation.
You must also be able to calculate the cost of new issues of ordinary shares from the information provided.
Exclude the use of the capital asset pricing model (CAPM) as a method to calculate the cost of ordinary shares for assignment and examination purposes. You need not study this method.
THE WEIGHTED AVERAGE FMA 101 COST OF CAPITAL (WACC)
The key concepts that you must focus on are:
- book value weights
- market value weights
- target weights
The capital structure can consist of a combination of different sources of finance, i.e. the capital structure can, for example, include debentures, preference shares, ordinary shares and retained earnings.
The cost of each of these sources may be different and the organisation can add these costs together in the proportion of each source expressed as a percentage of the total portfolio. The result is a weighted “average” cost of capital. Because it is calculated taking into account the proportion (weight) of each source of finance in the portfolio, it is referred to as the weighted average cost of capital (WACC).
You must be able to calculate the weighted average cost of capital using the information provided.
The weights of the different sources of capital in a capital structure are calculated in the same manner as explained in Table 6.3 of Topic 6 in this guide.
Although the weights of the sources of capital can be calculated in different ways, the WACC is always calculated at market values for purposes of financial decision-making.
THE WEIGHTED MARGINAL FMA 101 COST OF CAPITAL (WMCC)
The key concepts that you must focus on are the:
- marginal cost of capital
A business entity can calculate its WACC for its existing capital structure and base its investment and financing decisions on this WACC.
Should the entity, however, want to add additional new finance to the existing capital structure, then the existing WACC will most certainly change.
The change in the WACC that occurs between the current WACC and the WACC once the cost of capital of the additional finance has been included is referred to as the marginal change in the cost of capital.
The marginal change refers to the change in the WACC when the next rand of new investment is added. This marginal increase in the cost of capital is known as the weighted marginal cost of capital (WMCC).
New investment decisions will be based on the extent of the marginal increase in the WACC brought about by adding new finance to the capital structure.
A break point refers to the level of finance at which the cost of one of the sources of finance increases. Once such a break point is reached, the WACC will increase.
A break point is calculated using Equation 9.10 presented in the prescribed textbook.
You must be able to explain, discuss and calculate break points. Study Example 9.13 and Table 9.2 in the prescribed textbook. The example and table explain and demonstrate how to calculate and interpret a break point.
THE INVESTMENT OPPORTUNITY SCHEDULE (IOS)
An investment opportunity schedule (IOS) is a graph that is used to plot the amount of finance required for a particular investment opportunity on the horizontal axis and the WACC of the intended investment on the vertical axis.
A business entity can then use this schedule to ensure that it selects the best investment opportunities (highest possible return at the lowest possible risk) and utilises the capital it has available to invest to maximise shareholder wealth and the value of the business.
You need to be able to prepare an investment opportunity schedule using data and information provided.
Figure 9.1 and Table 9.3 in the prescribed textbook explain and demonstrate how to prepare and present an IOS.
COMBINING THE WMCC AND THE IOS
An entity can combine its WMCC and its IOS in order to optimise its investment decisions within the constraints of the financial resources it has available to invest.
You need to be able to combine the WMCC and IOS information of a business entity in order to provide the optimum investment opportunities for a business entity in terms of its capital constraints.
You need to study Table 9.3 and Figure 9.2 in the prescribed textbook. The table and the figure explain and demonstrate how a combination of the IOS and WMCC is used to optimise capital investment decisions within the constraints of a capital budget.
ADDITIONAL SOURCES TO ACCESS FMA 101 Topic 7
Access the following websites to broaden your understanding of the cost of capital in the context of financial management:
- Cost of capital: https://corporatefinanceinstitute.com/resources/knowledge/finance/cost- of-capital/, accessed 3 March 2020.
- The cost of capital formula: https://www.wallstreetmojo.com/cost-of- capital-formula/, accessed 3 March 2020.
SELF-ASSESSMENT EXERCISES FMA 101 Topic 7
At the end of this chapter, there is a series of different self-test problems, warm- up exercises, problems and a more comprehensive case study. You should attempt to answer these questions, perform the calculations and use them to practise and re-enforce your learning and understanding. You may submit any of your answers to the lecturer for assessment and feedback.
SBS also shares copies of previous exam papers with you during the semester. The questions in these exam papers are very good examples of what you are expected to know and be able to do having studied and mastered the content of chapter 9 of the prescribed textbook and having followed the guidance provided in this topic.