ABC Construction is a large company listed on Bursa Malaysia.A recently hired financial analyst asks how the
Question:
ABC Construction is a large company listed on Bursa Malaysia.A recently hired financial analyst asks how the company arrived at 10% as the discount rate to use when evaluating capital budgeting projects. After a brief discussion, the chief financial officer asked the person who raised the question in the first place to analyse the company's debt and equity and report back in a week with her estimate of the company's weighted average cost of capital.
She begin by gathering the following information: ABC has two outstanding bonds issues. Bond A mature in six years, has a par value of RM1,000.00, has a coupon rate of 7% paid semi-annually, and now sells for RM1,045.00. Bond B mature in sixteen years, has a par value of RM1,000.00, has a coupon rate of 8% paid annually, and now sells for RM1,050.00. The preferred stock has a par value of RM50, pays a dividend of RM1.50 and currently sells for RM19.00. The common stock sells for RM30.00 per share and recently paid a dividend of RM2.50. The company expects the dividend to grow at an average annual rate of 7% for the foreseeable future. The risk free rate is 4%, the expected rate of return on the market portfolio is 13%. ABC beta is 1.3, and its marginal tax rate is 24%.
ABC's capital by percentage using market value is as follow:
Bond A 15%
Bond B 20%
Preferred stock 10%
Common stock Not available
Retained earnings Not available
Total common equity 55%
a. Calculate the after-tax cost of debt for the bond issued.
b. Calculate cost of preferred stock.
c.Calculate cost of common equity. Use the average results from the dividend growth model and the Capital Asset Pricing Model.
d.Calculate weighted average cost of capital.
e.Some of ABC projects are low risk, some average risk, and some high risk. Should ABC use the same cost of capital to evaluate all its project or should it adjust the discount rate to reflect different levels of risk?