Question 1

The Randolph Limited has decided to acquire a new truck. One alternative is to lease the truck on a 4-year guideline contract for a lease payment of $10 000 per year, with payments to be made at the beginning of each year. The lease would include maintenance. Alternatively, Randolph Limited could purchase the truck outright for $40 000, financing the purchase by a bank loan for the net purchase price and amortizing the loan over a 4-year period at an interest rate of 10% per year. Under the borrow-to-purchase arrangement, RTC would have to maintain the truck at a cost of $1 000 per year, payable at year end. The truck falls into the MACRS 3-year class. It has a residual value of $10 000, which is the expected market value after 4 years, when Randolph Ltd plans to replace the truck irrespective of whether it leases or buys. Randolph Limited has a marginal tax rate of 40%.

Required:

1.1. What is Randolph's Present Value cost of leasing?

1.2. What is Randolph's Present Value cost of owning? Should the truck be leased or purchased?

1.3. The appropriate discount rate for use in the analysis is the firm's after-tax cost of debt. Why?

Question 2

AdvTech Limited is a large firm listed on the New York Stock Exchange. It has the following capital structure:

Long Term Capital $ million

Convertible Debt - 5 yrs; 8% 25

Preferred Shares - 5% coupon + nominal value of 100 15

Common Equity (nominal value $ 10/share) 10

Retained Earnings 23

The current dividend for the company is $ 50/share and is expected to grow at 3% per year in the foreseeable future. The equity shares trade at $ 450/share. The preferred shares trade at $ 104/share. The convertible debt has a conversion privilege of 2 shares per $ 1 000 face value at maturity. The debt currently trades at $ 950.

The firm's income tax rate is 30%

Required:

2.1. Calculate the firm's weighted average cost of capital (WACC).

2.2. Discuss the firm's dividend payout policy and whether it has an impact on share price.

2.3. Explain why the different sources of capital have different levels of risk and return.