BUSF_A01.qxd

Problems

10.1 What determines the value of an economic asset (as opposed to an asset that has

value for reason of sentiment)?

10.2 If we know the projected cash flows from loan notes and their current market value,

what approach would we take to deducing the cost of the loan notes?

10.3 Why does it seem likely that businesses have a ‘target’ gearing ratio?

10.4 What is wrong with using the cost of the specific capital used to finance a project as

the discount rate in relation to that project?

10.5 When calculating the weighted average cost of capital (WACC), should we use mar-

ket values or balance sheet values as the weights of debt and equity? Explain your

response.

10.6 When deducing the cost of equity through a dividend model, must we assume either

a constant level of future dividends or a constant level of growth of dividends? Explain

your response.

REVIEW QUESTIONS

Suggested answers to
review questions appear
in Appendix 3.

(Problems 10.1 to 10.4 are basic-level problems, whereas problems 10.5 and 10.6 are

more advanced and may contain some practical complications.)

10.1*Gregoris plc has some loan notes, currently quoted at £104 per £100 nominal value.

These will pay interest at the rate of 8 per cent p.a. of the nominal value at the end of

each of the next four years and repay £100 at the end of four years.

What is the cost of the loan notes? (Ignore taxation.)

10.2 Shah plc has a cost of equity of 17 per cent p.a. The business is expected to pay a

dividend in one year’s time of £0.27 per share. Dividends are expected to grow at

a steady 5 per cent each year for the foreseeable future.

What is the current price of one share in Shah plc?

10.3*Fortunate plc’s capital structure (taken from the balance sheet) is as follows:

£m

Ordinary shares of £0.50 each 8

10% preference shares of £1.00 5

Reserves 6

12% loan notes 10

The business pays corporation tax at the rate of 50 per cent and is expected to earn

a consistent annual profit, before interest and tax, of £9 million.

PROBLEMS

Sample answers to
problems marked with
an asterisk appear in
Appendix 4.

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