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Homework answers / question archive / Zainab Hassen Ali SAOC has two divisions: Division M and Division N
Zainab Hassen Ali SAOC has two divisions: Division M and Division N. Each division employs debt equal to 30% and preferred stock equal to 20% of its total requirements, with equity capital used for the remainder. The current borrowing rate after tax is 12%, and the company's tax rate is 30%. The preference share were issued at OMR 10.50 per share. The current market price per preference share is OMR 16.5 per share. The dividend per share is OMR 2.50. The company uses the dividend growth model to evaluate the cost of equity. The company plans to The company wishes to establish a minimum standard for each division based on the risk of that division. This standard then would serve as the transfer price of capital to the division. The company has taught about using the capital asset pricing model in this regard. It has identified two sample companies, with model value betas of 0.8 for Division M and 1.20 for Division N. Hassen Al Balushi SAOC had similar capital structures to that of Zainab Hassen Ali SAOC. The risk-free rate is currently 12% and the expected return on the market portfolio is 18%. a. Calculate the weighted average cost of capital for each division for Zainab Hassen Ali SAOC?
ANSWER -
|
Division |
M |
N |
|
Debt weight |
30% |
30% |
|
Preference Share weight |
20% |
20% |
|
Equity weight |
50% |
50% |
|
Total |
100% |
100% |
|
Borrowing Rate after tax |
12% |
12% |
|
Dividend per preference share |
2.50 |
2.50 |
|
Market Price per preference share |
16.50 |
16.50 |
|
Beta |
0.80 |
1.20 |
|
Risk free rate (Rf) |
12% |
12% |
|
Expected return on market portfolio (Rm) |
18% |
18% |
a. Calculation of WACC (Weighted Average Cost of Capital)
Cost of preference shares (rps)= Dividend on preference share / Current market price of preference shares
rps = 2.5/16.5 = 15.15%
Cost of equity for M (reM) = Rf + Beta*(Rm-Rf) = 12%+0.8*(18%-12%) = 16.80%
Cost of equity for N (reN) = Rf + Beta*(Rm-Rf) = 12%+1.2*(18%-12%) = 19.20%
Formula for WACC
WACC = Wd * (rd * (1-Tax)) + Wps * rps + We * re
Wd,Wps &We – Weights of debt, preference shares & equity shares, respectively
rd,rps & re - Required returns debt, preference shares & equity shares, respectively
For division M
WACC = 0.3*12% + 0.2*15.15% + 0.5*16.80% = 15.03%
For division N
WACC = 0.3*12% + 0.2*15.15% + 0.5*19.20% = 16.23%
