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    Weighted Average cost of Capital (WACC)

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    Summary of the balance sheet of XYZ below

    Balance sheet of XYZ as at 31 December 2009 ('000)

    Cash R10 Account payable R10
    Accounts receivable 20 Acruals 10
    Inventories 20 Short-term debt 5
    Current assets R50 Current liabilities R 25
    Net fixed assets 50 Long term debt 30
    Preference shares 5
    Ordinary equity
    Ordinary shares 10
    Retained earnings 30
    Total(ordinary) equity 40
    Total assets R100 Total liabilities and equity R100

    The following facts are also given for XYZ:

    (i) Short-term debt consists of bank loans that currently cost 10
    percent, with interest payable quarterly. These loans are used to
    finance receivables and inventories on a seasonal basis, so in
    the off-season, bank loans are zero.

    (ii) The long-term debt consists of 20-year, semi-annual payment
    bonds with a coupon rate of 8 percent. Currently, these bonds
    provide a yield to investors of Rd = 12 percent. If new bonds
    were sold, they would yield investors 12 percent. If new bonds
    were sold, they would yield investors 12 percent.

    (iii) A XYZ preference share has a R100 par value, pays a
    quarterly dividend of R2, and has a yield to investors of 11
    percent. New preference shares would have to provide the same
    yield to investors, and the company would incur a 5 percent
    flotation cost to sell it.

    (iv) The company has 4 million ordinary shares outstanding. The
    shares have recently traded in a range of R17 to R23 with Po =
    R20 as the most likely current price. Do = R1 and EPSo = R2.
    ROE based on average equity was 24 percent in 2008, but
    management expects to increase this return on equity to 30
    percent; however, security analysts are not aware of
    management's optimism in this regard.

    (v) Beta coefficients for XYZ, as reported by security analysts,
    range between 1,3 to 1,7. A Beta coefficient of 1,5 seems the
    most likely value. The T-bill rate is 10 percent, and rM is
    estimated by various brokerage houses to be in the range of
    14,5 to 15,5 percent.

    (vi) XYZ is in the 40 percent tax bracket.

    (viii) XYZ's investment banker, predicts a decline in interest rates,
    with rd falling to 10 percent and the T-bill rate to 8 percent,
    although XYZ's investment banker acknowledges that an
    increase in the expected inflation rate could lead to an increase
    rather than a decrease in rates.

    (ix) Growth in dividends, as estimated by the retention growth model
    [g = b(r)] is 12 percent.
    Based on the information provided, you are required to estimate the
    company's Weighted Average cost of Capital (WACC). Assume that no
    new equity will be issued. Your WACC estimate should be appropriate for
    use in evaluating projects which are in the same risk class as the firm's
    average assets now on books.

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    Solution Summary

    The solution explains how to calculate the Weighted Average cost of Capital (WACC).

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