Assume that you are assisting financial VP, Jake Lewis of Spencer Technologies (ST). Your first task is to estimate STs cost of capital. Mr Lewis has provided you with the following data, which he believes is relevant to your task:

1. (1) The firms marginal tax rate is 40%.

2. (2) The current price of STs noncallable bond (12 % per annum coupon with 15 years

remaining to maturity) is 1,153.72. ST does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost. (3) The current price of the firms preferred stock (10%, 100 par value, perpetual quarterly dividend) is 113.10. ST would incur flotation costs of 2 per share on a new issue of preferred stock. (4) STs common stock is currently selling at 50 per share. Its last dividend (D0) was 4.19, and dividends are expected to grow at a constant rate of 5% in the near future. STs beta is 1.2, the yield on Treasury bonds is 7%, and the market risk premium is estimated to be 6%. The firm uses a four percentage point risk premium under the bond-yield-plus-risk- premium approach. (5) The floatation cost of issuing new common stock is 15% for value up to 300,000 and 25% for value above 300,000. (6) STs target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity. (7) The forecast retained earnings for the coming year are 300,000.

To structure the task somewhat, Lewis has asked you to answer the following questions:

a. (1) (2) What is the firms cost of preferred stock? (5 marks)

What is the market interest rate on STs debt and its component cost of debt?

b. (1) (2) What is STs overall, or weighted average, cost of capital (WACC) when

What is STs estimated cost of retained earnings using the CAPM approach?

(6 marks) retained earnings are used as the equity component? (8 marks)

Question 2

Cork plc (a UK company) owns an on-shore oil field in Scotland that was purchased from the government in 20X2. In recent years, the performance of the field has been badly affected by the impact of fossil fuels on climate change, business conditions and other technological developments in the oil drilling industry. Drilling engineers employed by the company believe that the field could be profitably operated for another four years after netting off the relevant expenses. If the field is operated during this period, the following financial results are expected:

Operating profit (loss) Interest payable

Year 1 2 3 4 m m m m 54 (46) (15) 22

(11) (11) (11) (11) Page 2 of 5

(6 marks)

Net profit (loss) for the year 43 (57) (26) 11

The following seven points of additional information are available:

(i) The machinery and equipment at the field cost 18 million and have a written down value of 8 million. The machinery and equipment will be sold at the end of the four-year period for an estimated 2 million.

(ii) A depreciation charge for the machinery and equipment of 1.5 million per year and an amortisation* charge for depletion of the field of 4 million per year are included in the above calculations. (iii) The working capital tied up in the field is 3.6 million and this can be liquidated as soon as the company stops its operations.

(iv) Redundancy payments to employees will amount to 2.2 million if the company operates the field for the further four years and then releases employees at the end of this period. (v) The company has agreed with the UK government to fill in the field and build a community centre in the area in five years time. This is estimated to cost 2.5 million and this commitment will not be affected by any decisions concerning the future of the field.

(vi) The company has been approached by an oil drillers co-operative, consisting of employees of the field. The co-operative has offered to lease the field for the remaining four years of its life at a lease rental of 6.0 million per year, payable at the end of each year. The co-operative has also offered to buy the existing machinery and equipment from the company for 5.0 million immediately if a lease agreement can be reached. It has also offered to make a contribution of 1.5 million towards the cost of building the community centre in five years time. No other parties have declared an interest in taking over the drilling operations. If the company agrees to lease the field, and thereby discontinue operations, it will have to make redundancy payments of 3.4 million immediately. (vii) Cork plc has a cost of capital of 10%.

When answering this question, ignore taxation.

*Amortisation: The practice of reducing the value of assets to reflect their reduced worth over time. The term means the same as depreciation, though in practice amortisation tends to be used for the write-off of intangible assets, such as goodwill, while either term is used for the write-off of fixed capital. (Financial Times Lexicon)

(a) Given the above definition for amortisation, explain if amortisation is a relevant expense in the computation of cash flows.

(3 Marks)

(b) Calculate the incremental cash flows if Cork were to continue operations for a further four years rather than lease the field to the drillers co-operative.

(4 Marks)

(c) Calculate the net present value of continuing operations for a further four years rather than leasing the field to the drillers co-operative. (14 Marks) (d) State whether the company should continue to operate the field or lease the field to the cooperative. You should clearly state your reasons and any key assumptions that you have made in arriving at your decision.