Financial Management

1 (a) Weighted average cost of capital (WACC) calculation

Cost of equity of KFP Co = 4·0 + (1·2 x (10·5 – 4·0)) = 4·0 + 7·8 = 11·8% using the capital asset pricing model

To calculate the after-tax cost of debt, linear interpolation is needed

After-tax interest payment = 100 x 0·07 x (1 – 0·3) = $4·90

Year Cash flow $ 10% discount PV ($) 5% discount PV ($)

0 Market value (94·74) 1·000 (94·74) 1·000 (94·74)

1 to 7 Interest 4·9 4·868 23·85 5·786 28·35

7 Redemption 100 0·513 51·30 0·711 71·10

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(19·59) 4·71

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After-tax cost of debt = 5 + ((10 – 5) x 4·71)/(4·71 + 19·59) = 5 + 1·0 = 6·0%

Number of shares issued by KFP Co = $15m/0·5 = 30 million shares

Market value of equity = 30m x 4·2 = $126 million

Market value of bonds issued by KFP Co = 15m x 94·74/100 = $14·211 million

Total value of company = 126 + 14·211 = $140·211 million

WACC = ((11·8 x 126) + (6·0 x 14·211))/140·211 = 11·2%

(b) (i) Price/earnings ratio method

Earnings per share of NGN = 80c per share

Price/earnings ratio of KFP Co = 8

Share price of NGN = 80 x 8 = 640c or $6·40

Number of ordinary shares of NGN = 5/0·5 = 10 million shares

Value of NGN = 6·40 x 10m = $64 million

However, it can be argued that a reduction in the applied price/earnings ratio is needed as NGN is unlisted and thereforeits shares are more difficult to buy and sell than those of a listed company such as KFP Co. If we reduce the appliedprice/earnings ratio by 10% (other similar percentage reductions would be acceptable), it becomes 7·2 times and thevalue of NGN would be (80/100) x 7·2 x 10m = $57·6 million