AFM Exam Questions for Costs of capital

?     Pursue new business: 201412Q1(C2)

?     Sell a part of own business: 201212Q1(a)

?     Comparison of different business proposals: 201612Q1(b)

Pursue new business: 201412Q1(C2)

In recent years, the country in which Fugae Co is based has been expanding its tourism industry and hopes that this industry will grow significantly in the near future. At present tourists normally travel using public transport and taxis, but there is a growing market for luxury travel. If the tourist industry does expand, then the demand for luxury travel is expected to grow rapidly. Fugae Co is considering entering this market through a four-year project.

The market value of Fugae Co's equity is $922.5 million and its non-current liabilities consist entirely of $100 nominal value bonds which are redeemable in four years at the nominal value, on which the company pays a coupon of 5.4%. The debt is rated at B+ and the credit spread on B+ rated debt is 80 basis points above the risk-free rate of return.

Given below are extracts from the most recent statements of financial position of both Avem Co and Fugae Co.

Although there is no beta for companies offering luxury forms of travel in the tourist industry, Reka Co, a listed company, offers passenger transportation services on coaches, trains and luxury vehicles. About 15% of its businessis in the luxury transport market and Reka Co‘s equity beta is 1.6. It is estimated that the asset beta of the non-luxury transport industry is 0.80. Reka Co’s shares are currently trading at $4.50 per share and its debt is currently trading at $105 per $100. It has 80 million shares in issue and the book value of its debt is $340 million. The debt beta isestimated to be zero.

The corporation tax rate applicable to all companies is 20%. The risk-free rate is estimated to be 4% and the market risk premium is estimated to be 6%.

Required:

ü  Calculate a suitable cost of capital to apply to the luxury forms of travel project.

Answer to Pursue new business: 201412Q1(C2)

Market Value of Fugae Co's equity and debt

Fugae Co

Mve = $922.5m

MVd

Cost of debt = Risk free rate return plus the credit spread

=4%+0.80%=4.80%

Current value of a $100 bond: $5.4×1.048^-1+ $5.4×1.048^-2 + $5.4×1.048^-3

+ $5.4×1.048^-4= $102.14 per $100

MVd = 1.0214×$380m= $388.1m

1. Find the appropriate equity beta from a suitable quoted company

2. Adjust the available equity beta to convert it to an asset beta-degear it.

3. Readjust the asset beta with new capital structure weightings to reflect the project(i.e. its own) gearing levels-regear the beta.

Project's risk adjusted equity beta:

ü  1.4 × ($922.5m + $388.1m × 0.8) / $922.5m = 1.87

4. Calculate the cost of equity of the project based on CAPM(Ke)

E(ri)=Rf+β(E(Rm)-Rf)

Project‘s risk adjusted cost of equity：

ü  4% + 1.87 × 6% = 15.2%

Pursue new business: 201412Q1(C2)

5. Calculate the WACC of the project with the calculated Ke.

WACC=()×Ke+ ()×Kd×(1-T)

Project’s risk adjusted cost of capital:

ü  (15.2% × $922.5m + 4.8%×0.8 ×$388.1m) / ($922.5m + $388.1m) = 11.84%, say 12%