FALL SEMESTER 2006

BUSINESS FINANCE ( ACC501 )

Solution for Assignment # 05

1. Consider the following information related to two companies of the same industry
as on Dec. 31, 2006.

S&T Company A2Z Company

Share Capital (Rs.10 each) Rs. 850,000 Rs. 1,400,000
Reserves Rs. 320,000 Rs. 500,000
Retained Earnings Rs. 200,000 Rs. 250,000
Current Year Dividend 20 % (Rs. 2.0) 16 % (Rs. 1.60)
Dividend Growth Rate 10% 5%
Market Price of Common Rs. 15 Rs. 12
Stock
Required:
Which company’s capital structure is more efficient? Support your answer with
calculations.
[Hint: Compare Cost of Equities of both of the companies.]

Answer
S&T Company

Cost of Equity
P0 = D0 (1+g) / RE –g
15 = 2 (1.10) / RE – 0.1
15RE - 1.5 = 2.20
15RE = 3.70
RE = 3.70 / 15
RE = 0.2467 or 24.67 %

A2Z Company

Cost of Equity
P0 = D0 (1+g) / RE –g
12 = 1.6 (1.05) / RE – 0.05
12RE – 0.6 = 1.68
12RE = 2.28
RE = 2.28 / 12
RE = 0.19 or 19.00 %

Capital Structure for A2Z Company is more efficient because its Cost of Equity is
less than that of S&T Company.
2. Sumi Inc. presently paid a dividend of Rs.1 per share and has a share price of
Rs.20. The dividends are expected to grow @ 12% forever. The Sumi Inc. has Rs.100
million in equity and Rs.75 million in debt in its total capital. The tax rate for the
 FALL SEMESTER 2006
BUSINESS FINANCE ( ACC501 )
Solution for Assignment # 05
firm is 30% and the Cost of debt is 8%. What is Weighted Average Cost of Capital
(WACC)?

Solution:
Cost of Equity
P0 = $20,
G = 12%
D0 = $1
So,
P0 = D0 (1+g) / RE –g
20 = 1 (1.12) / RE – 0.12
20 (RE - 0.12) = 1.12
20RE - 2.4 = 1.12
20RE = 3.52
RE = 3.52/20
RE = 0.176 or 17.6%

WACC
Equity = $ 100 M
Debt = $ 75 M
Tc = 30%
RE = 17.6%
RD = 8%
WACC = ?
WACC = (E/V) x Re + [(D/V) x RD x 1 - TC]
WACC = (100/175) x 0.176 + [(75/175) x 0.08 x 1 - 0.30]
WACC = 0.57 x 0.176 + [0.43 x 0.08 x 0.70]
WACC = 0.10032 + [0.0344 x 0.70]
WACC = 0.10032 + 0.02408
WACC = 0.1244 or 12.44%