INDIVIDUAL ASSIGNMENT

FINANCIAL MANAGEMENT (ACC209)

Submitted to: Ahmed Salih

Date: 2nd May 2013

Student Name: Shahuma Khalid

Student ID No: 7427
Bachelors of Business
Faculty of Management and Computing
 Individual Assignment

Humble Manufacturing is interested in measuring its overall cost of capital. The firm is in
the 40% tax bracket. Current investigation has gathered the following data:

Debt: The firm can raise an unlimited amount of debt by selling $1,000-parvalue, 10%
coupon interest rate, 10-year bonds on which annual interest payments will be made.
To sell the issue, an average discount of $30 per bond must be given. The firm must also
pay flotation costs of $20 per bond.

Preferred stock: The firm can sell 11% (annual dividend) preferred stock at its $100-per-
share par value. The cost of issuing and selling the preferred stock is expected to be $4
per share. An unlimited amount of preferred stock can be sold under these terms.

Common stock: The firms common stock is currently selling for $80 per share. The firm
expects to pay cash dividends of $6 per share next year. The firms dividends have been
growing at an annual rate of 6%, and this rate is expected to continue in the future. The
stock will have to be underpriced by $4 per share, and flotation costs are expected to
amount to $4 per share. The firm can sell an unlimited amount of new common stock
under these terms.

Retained earnings: The firm expects to have $225,000 of retained earnings available in
the coming year. Once these retained earnings are exhausted, the firm will use new
common stock as the form of common stock equity Financing.

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 Individual Assignment

a. Calculate the specific cost of each source of financing. (Round to the nearest 0.1
%.)

Answer) Cost of Debt

$1000
+
=
+ 1000
2

$1000 (1000 30 20)

(1000 10%) +
= 10
950 + 1000
2

$1000 950
100 +
= 10
950 + 1000
2

105
=
975

= 10.8

After tax

= (1 )

= 10.8 (1 0.40)

=6.5%

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 Individual Assignment

Cost of preferred stock

11
=
(1004)

=11.50%

Cost of common stock

1
= +

11
+ 6%
80

=13.5

Cost of new common stock

1
= +

11
+ 6%
(80 4 4)

=14.3

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 Individual Assignment

b. The firm uses the weights shown in the following table, which are based on
target capital structure proportions, to calculate its weighted average cost of
capital. (Round to the nearest 0.1 %.)

Source of Capital Weight

Long-term debt 40%
Preferred Stock 15
Common stock Equity 45
Total 100

Answer) Weighted Average Cost of Capital

Source of Capital Cost of Capital Weight WACC

Long term Debt 6.4 0.40 2.5
Preferred 11.4 0.15 1.8
Common stock 13.5 0.45 6.1
total 10.4

(1) Calculate the single break point associated with the firms financial situation.
(Hint: This point results from exhaustion of the firms retained earnings.)
Answer)

Common equity = =

225000
0.45
= 500000

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 Individual Assignment

(2) Calculate the weighted average cost of capital associated with total new
financing below the break point calculated in part (1).
Weighted Average Cost of Capital for Ranges of total new financing of Humble
manufacturing
Range of total new financing

0 - 225000

Source of Capital Cost of Capital Weight WACC

Long term Debt 6.4 0.40 2.5
Preferred 11.4 0.15 1.8
Common stock 13.5 0.45 6.1
total 10.4

< 500000

Source of Capital Cost of Capital Weight WACC

Long term Debt 6.4 0.40 2.5
Preferred 11.4 0.15 1.8
Common stock 14.3 0.45 6.4
total 10.7

(3) Calculate the weighted average cost of capital associated with total new
financing above the breakpoint calculated in part (1).

> 500000
Source of Capital Cost of Capital Weight WACC
Debt 6.4 0.40 2.5
Preferred 11.4 0.15 1.8
Common stock 14.6 0.45 6.6
total 10.9

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 Individual Assignment

c. Define cost of capital and explain the key assumptions made relating to risk in
isolate the basic structure of the cost of capital
Answer) the cost of capital is the rate of return that a firm must earn on the
projects in which it invests to maintain the market value of its stock. The cost of
capital provides benchmark against which the potential rate of return on an
investment is compared.
The cost of capital is a dynamic concept affected by a variety of economic and
firm-specific factors. To isolate the basic structure of the cost of capital, we make
some key assumptions relative to risk and taxes:

1. Business riskholding business risk constant assumes that the acceptance

of given project leaves the firms ability to meet its operating expenses
unchanged. (Gitman)
2. Financial riskholding financial risk constant assumes that the acceptance
of a given project leaves the firms ability to meet its required financing
expenses unchanged. By doing this it I possible to more easily calculate the
firms cost of capital, which is a factor taken into consideration in evaluating
new projects.

d. Explain why the cost of capital is measured on an after-tax basis why is use of a
weighted average cost of capital rather the cost of the specific source of funds
recommended?
Answer) The cost capital is measured on after tax basis in order to be consistent
with the capital budgeting framework. The only component of the capital that
actually requires a tax adjustment is the cost of debt, since interest is on debt,
since interest is on debt is treated as a tax-deductible expenditure. Measuring
the cost of debt on an after-tax basis reduces the cost. The weighted average
cost is recommended over the cost of the source of fund used for the project.

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 Individual Assignment

The interrelatedness of financing decision assuming the presence of a target

capital structure is reflected in the weighted average cost of capital.

e. Explain briefly five methods used to evaluate capital investment projects

Answer)
1. Payback: This calculates the number of years it will take to recoup the cash spent
on a project. A criticism of payback is that the time value of money is not
considered and the cash flows over the entire life of the project are not
considered. All else being equal, shorter payback periods are preferable to
longer payback periods. Payback period is widely used because of its ease of use.

2. Net present Value: This method discounts the projects future cash flows by a
predetermined rate, such as the targeted or needed rate. If the cash flows
discounted by the targeted rate exceed the cash investment, the project is
accepted. That is, the project provides the targeted return or more

3. Internal Rate of Return: This method does consider the time value of money and
looks at the cash flows over the entire life of the project. The technique
computes the rate that will discount the future cash flows to be equal to the
cash outlay for the project. IRR calculations are commonly used to evaluate the
desirability of investments or project. The higher a projects IRR, the more
desirable it is to undertake the project.

4. Accounting Rate of Return or Return on Investment: This approach looks at the

increase in accounting profit compared to the increased investment. This
approach also ignores the time value of money. ARR is a percentage return. If
the ARR is equal to or greater than the required rate of return, the project is
acceptable. If it is less than the desired rate, it should be rejected. When
comparing, the higher the ARR, the more attractive the investment.

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 Individual Assignment

5. Profitability Index (PI): It is useful tool for ranking projects, because it allows you
to quantify the amount of value created per unit of investment. The ratio is
calculated as follows:

Profitability index = PV of future cash flows / Initial Investment

As the value of the profitability index increases, so does the financial

attractiveness of the proposed project. Rules for selection or rejection of a
project:
If PI > 1 then accept the project
If PI < 1 then reject the project

(Ranking Investment proposals)

(Understanding the Weighted Average Cost of Capital (WACC))

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 Individual Assignment

Bibliography

Gitman, L. J. (n.d.). Principles of Managerial Finance. New Jersey: Prentice Hall.

Ranking Investment proposals. (n.d.). Retrieved April 27, 2013, from www.boundless.com:
https://www.boundless.com/finance/capital-budgeting/introduction-to-capital-
budgeting/ranking-investment-proposals/

Understanding the Weighted Average Cost of Capital (WACC). (n.d.). Retrieved April 27, 2013,
from Qfinance website: http://www.qfinance.com/balance-sheets-
checklists/understanding-the-weighted-average-cost-of-capital-wacc