Estimating the cost of capital

**Section A** AstroTours PLC, a space-tourism company, has just paid a dividend of $0.40 per share. The current share price is $5.20. Historically, dividends have grown at a steady rate of 5% per annum, and this is expected to continue indefinitely. Using the Dividend Valuation Model (DVM), what is AstroTours' estimated cost of equity?

**Section C** **AeroForge PLC - Cost of Capital** AeroForge PLC manufactures specialized components for the aerospace industry. The company is looking to calculate its Weighted Average Cost of Capital (WACC) to appraise future investments. The company's capital structure is as follows: **Equity:** AeroForge has 10 million ordinary shares in issue, currently trading at $4.50 per share. The company's equity beta is estimated to be 1.20. The current risk-free rate of return is 3.0%, and the expected return on the market portfolio is 10.0%. **Debt:** AeroForge has $20 million (nominal value) of irredeemable bonds in issue. The bonds pay an annual coupon of 6%. The current market price of the bonds is $95.00 per $100 nominal value. **Other Information:** - The corporate tax rate is 20%. - AeroForge intends to maintain its current capital structure proportions for the foreseeable future. **Required:** **(a)** Calculate the Cost of Equity for AeroForge PLC using the Capital Asset Pricing Model (CAPM). (4 marks) **(b)** Calculate the after-tax Cost of Debt for the irredeemable bonds. (4 marks) **(c)** Calculate the Weighted Average Cost of Capital (WACC) for AeroForge PLC. (6 marks) **(d)** The directors of AeroForge are considering diversifying into the commercial drone delivery market. Discuss whether the current WACC calculated in part (c) would be appropriate to appraise this new project, and explain how a project-specific discount rate could be determined. (6 marks)

Section A ServicePro Co has a market value of equity of $60 million and a market value of debt of $40 million. The cost of equity is 12% and the pre-tax cost of debt is 6%. The corporation tax rate is 25%. Calculate the Weighted Average Cost of Capital (WACC) for ServicePro Co. (Enter your answer as a percentage to one decimal place, e.g., 8.5)

Section A Alpha Co is an all-equity financed company with an equity beta of 1.2. It plans to change its capital structure to 30% debt and 70% equity. The risk-free rate is 4% and the market risk premium is 6%. Corporation tax is 20%. Assuming debt is risk-free (debt beta = 0), what will be Alpha Co's new equity beta after the gearing change?

Section B - Case 2: Helios Co Helios Co operates wind farms across Europe. It is looking to acquire a smaller competitor, Aura Ltd. To assess the acquisition, Helios needs to calculate its own Weighted Average Cost of Capital (WACC) and value Aura Ltd. Helios Co Data: Current share price: $4.50 Recent dividend paid (D0): $0.30 Historical dividends: 4 years ago: $0.24 3 years ago: $0.25 2 years ago: $0.27 1 year ago: $0.28 Using the historical dividend growth rate, what is Helios Co's estimated Cost of Equity (Ke) using the Dividend Valuation Model?

Section B - Case 2: Helios Co To fund the acquisition, Helios Co plans to issue a significant amount of new debt, changing its capital structure. According to Modigliani and Miller's theory with corporate taxes, what will be the impact of this increased gearing on Helios Co's WACC and Firm Value?

'AquaPure', a water desalination utility, has a market value of equity of $10 million and a market value of debt of $5 million. The cost of equity is 12% and the pre-tax cost of debt is 8%. The corporate tax rate is 25%. Calculate AquaPure's Weighted Average Cost of Capital (WACC). (Enter your answer as a percentage to one decimal place, e.g., 10.5. Do not include the % sign)

'RoboMinds', an AI robotics firm, is considering diversifying into autonomous agricultural vehicles. This new venture has a significantly different risk profile from its current operations. Why is it inappropriate for RoboMinds to use its current Weighted Average Cost of Capital (WACC) to appraise this new project?

CASE 2: AERODRONE TECH AeroDrone Tech is an ungeared manufacturer of commercial delivery drones. The company currently has a cost of equity of 12%. The board is considering a major restructuring to issue debt and repurchase equity. The corporate tax rate is 25%. The risk-free rate is 4% and the equity risk premium is 6%. Using the Capital Asset Pricing Model (CAPM), what is AeroDrone's current asset beta (ungeared beta)?

**Section A** Titanium Forge PLC, a heavy manufacturing firm, has an equity beta of 1.40. The company's capital structure consists of 60% equity and 40% debt by market value. The corporate tax rate is 25%. Assuming debt is risk-free (debt beta is zero), calculate the asset beta of Titanium Forge PLC to two decimal places.

**Section A** AlphaTech PLC has $5 million of convertible bonds in issue. The bonds pay an annual coupon of 6% and are redeemable in 4 years at par, or convertible into 20 ordinary shares per $100 bond. The current share price is $4.50 and is expected to grow at 5% per year. The pre-tax cost of debt is 8% and the corporate tax rate is 25%. When calculating the Weighted Average Cost of Capital (WACC), how should the cost of this convertible debt be determined?

**Section B - Case 2: AeroDynamics PLC** *Scenario:* AeroDynamics PLC, an aerospace manufacturer, is evaluating the acquisition of a target company, HeliParts. HeliParts has just paid an annual dividend of $0.40 per share. Historical dividend data shows that 4 years ago, the dividend was $0.32 per share. HeliParts' cost of equity is estimated at 12%. The company has 5 million ordinary shares in issue. HeliParts also has $10 million of 8% irredeemable bonds trading at $105 per $100 nominal value. The corporate tax rate is 25%. What is the after-tax cost of debt for HeliParts' irredeemable bonds?

**Section A** MediScan Diagnostics is calculating its Weighted Average Cost of Capital (WACC) to appraise a new MRI facility. The finance director is debating whether to use book values or market values for the weighting of equity and debt. According to financial management theory, which of the following statements regarding WACC weightings is correct?

**Section A** CyberShield Inc, a software company, is pivoting to hardware manufacturing. To find an appropriate discount rate, it looks at a proxy hardware company, HardTech PLC. HardTech PLC has an equity beta of 1.5. Its capital structure is 60% equity and 40% debt by market value. The corporate tax rate is 25%. Assuming debt is risk-free (debt beta is zero), what is the asset beta of HardTech PLC?

**Section B - Case 3: AeroFreight Logistics** *Scenario:* AeroFreight Logistics operates drone deliveries across Europe and Asia. The company is based in the UK (GBP). It owes a supplier €500,000 payable in 6 months. Spot rate: €1.1500 - €1.1550 / £1 6-month forward rate: €1.1400 - €1.1460 / £1 UK 6-month borrowing rate: 4% (annual) Euro 6-month deposit rate: 2% (annual) **Question 3:** AeroFreight's current share price is £3.50. It has just paid a dividend of £0.25. Dividends have grown from £0.20 four years ago. Using the historical dividend growth rate, what is AeroFreight's estimated cost of equity? (Round to one decimal place)

**Section B - Case 3: AeroFreight Logistics** *Scenario:* AeroFreight Logistics operates drone deliveries across Europe and Asia. The company is based in the UK (GBP). It owes a supplier €500,000 payable in 6 months. Spot rate: €1.1500 - €1.1550 / £1 6-month forward rate: €1.1400 - €1.1460 / £1 UK 6-month borrowing rate: 4% (annual) Euro 6-month deposit rate: 2% (annual) **Question 4:** AeroFreight has irredeemable debt in issue with a nominal value of £100, paying an annual coupon of 6%. The current market price of the debt is £80 ex-interest. The corporate tax rate is 25%. What is the post-tax cost of this debt?

**Section C** **AquaGrid Networks** AquaGrid Networks is a public utility company planning to build a new desalination plant. The board is reviewing both its working capital policy and its overall cost of capital. **Part 1: Working Capital Policy** AquaGrid currently adopts a conservative working capital financing policy. The new CFO is proposing a shift to an aggressive working capital financing policy to improve profitability. **Part 2: Cost of Capital** To fund the desalination plant, AquaGrid will issue new 'Green Bonds'. The current capital structure (by market value) is: - Equity: $60 million - Debt: $40 million The current cost of equity is 12%, and the current post-tax cost of debt is 5%. The new Green Bond issue will raise $20 million. The post-tax cost of this new debt will be 4%. Because of the increased gearing, the cost of equity is expected to rise to 14%. The existing debt's cost will remain at 5%. **Required:** (a) Explain the difference between a conservative and an aggressive working capital financing policy. Discuss the impact this shift will have on AquaGrid's profitability and liquidity risk. (8 marks) (b) Calculate AquaGrid's current Weighted Average Cost of Capital (WACC) before the new bond issue. (4 marks) (c) Calculate AquaGrid's revised WACC after the $20 million Green Bond issue. (4 marks) (d) Based on your calculations in (b) and (c), explain whether the new bond issue has maximized shareholder wealth according to the traditional view of capital structure. (4 marks)

Section A LexAI, an AI-driven legal services firm, is entirely equity financed with an equity beta of 1.4. It plans to diversify into a new industry (cloud data storage) and has identified a proxy company in that industry. The proxy company has an equity beta of 1.2 and a debt-to-equity ratio of 1:3 by market value. The corporate tax rate is 25%. What is the asset beta of the proxy company? (Round to two decimal places)

Section A WindForce Inc has issued convertible green bonds. The current market value is $105 per $100 nominal value. The bonds pay annual interest of 5% and mature in 4 years. At maturity, investors can either redeem at par or convert into 20 ordinary shares. The current share price is $4.50 and is expected to grow at 6% per year. The corporate tax rate is 20%. What is the expected conversion value of the bond at maturity?

Section B - Case 2: NeuroLink Prosthetics Scenario: NeuroLink Prosthetics is a MedTech firm. It has 10 million ordinary shares in issue, currently trading at $4.50 per share. The company's equity beta is 1.2. The risk-free rate of return is 4% and the expected return on the market portfolio is 10%. NeuroLink also has $15 million (nominal value) of 6% redeemable bonds, currently trading at $95 per $100 nominal, redeemable at par in 5 years. The corporate tax rate is 25%. Question: Using the Capital Asset Pricing Model (CAPM), what is NeuroLink's cost of equity?

Section B - Case 2: NeuroLink Prosthetics Scenario: NeuroLink Prosthetics is a MedTech firm. It has 10 million ordinary shares in issue, currently trading at $4.50 per share. The company's equity beta is 1.2. The risk-free rate of return is 4% and the expected return on the market portfolio is 10%. NeuroLink also has $15 million (nominal value) of 6% redeemable bonds, currently trading at $95 per $100 nominal, redeemable at par in 5 years. The corporate tax rate is 25%. Question: Which of the following cash flows should be used to calculate the after-tax cost of debt (Kd) for the redeemable bonds using the Internal Rate of Return (IRR) method?

Section B - Case 2: NeuroLink Prosthetics Scenario: NeuroLink Prosthetics is a MedTech firm. It has 10 million ordinary shares in issue, currently trading at $4.50 per share. The company's equity beta is 1.2. The risk-free rate of return is 4% and the expected return on the market portfolio is 10%. NeuroLink also has $15 million (nominal value) of 6% redeemable bonds, currently trading at $95 per $100 nominal, redeemable at par in 5 years. The corporate tax rate is 25%. Assume the cost of equity (Ke) is 11.2% and the after-tax cost of debt (Kd) is 5.7%. Question: What is NeuroLink's Weighted Average Cost of Capital (WACC) based on market values?