Question 1

Read through the information below and answer the questions that follow.

a. This part of the question asks you to calculate Weighted Average Cost of Capital (WACC) for three different companies and explain some issues surrounding the calculations. Show all your workings.

i. Collection AG has 3 million shares in issue. The current market price is 8 per share. The companys debt is publicly traded on the Frankfurt Stock Exchange and the most recent quote for its price was at 80% of face value. The debt has a total face value of 9 million and Collections credit risk premium is currently 4%. The risk-free rate is 2% and the equity market risk premium is 4%. The companys equity beta is estimated at 1.3 and its corporate tax rate is 40%. Calculate Collection AGs WACC.

ii. Fancy Soap plc has an average market cost of borrowing of 5% per year and an equity beta of 1.1. Fancy Soap has a constant debt to equity ratio of 2:1 and a corporate tax rate of 35%. The expected return on the market portfolio is 18% and the expected risk-free rate is 3%. Calculate the WACC for Fancy Soap plc.

iii. Given the following data, calculate Flagship Entertainment plcs weighted average cost of capital (WACC):

Risk-free rate = 5% p.a.

Flagships equity beta = 0.5

Flagships current share price = 5.86

Number of Flagship shares in issue = 7.2 million

Flagships credit risk premium = 2% p.a.

Flagships current market value of debt = 13m

Equity risk premium = 7.5% p.a.

Flagship plcs corporate tax rate = 28%

iv. The companies in (i) and (ii) above have a beta greater than 1.0. Explain what an equity beta of greater than 1.0 means. What are the benefits for managers in knowing the cost of equity capital of their company?

b. How do credit ratings agencies help facilitate efficient capital markets?

c. A firm is planning to increase its international business without changing its gearing. With reference to the Capital Asset Pricing Model (CAPM), how would this affect the firms cost of equity?