BUSF_A01.qxd

Suggested answers to selected problem questions

10.5 Da Silva plc

(a)

Year Growth

2 (0.0900 −0.0800)/0.0800 =0.125

3 (0.1050 −0.0900)/0.0900 =0.167

4 (0.1125 −0.1050)/0.1050 =0.071

5 (0.1250 −0.1125)/0.1125 =0.111

6 (0.1350 −0.1250)/0.1250 =0.080

7 (0.1450 −0.1350)/0.1350 =0.074

8 (0.1550 −0.1450)/0.1450 =0.069

Sum 0.697

Arithmetic mean =10%

(The mean could be calculated from the more recent data and/or a weighting used.)

kE=[d 0 (1 +g)/V 0 ] +g

=[£0.1550(1 +0.1)/2.75] +0.10

=16.2%

Hence:

WACC ==14.2%

(b) The main assumption being made in the estimation of the WACC figure is that past

experience is a good guide to the future. More specifically:

l that the risk of the proposed investment is similar to the average risk of the busi-

ness’s recent past activities;

l that past dividend growth is similar to future prospects. This seems a dubious

assumption in this particular case since the dividend growth rate has been very

erratic from one year to the next;

l that future interest and tax rates are likely to be similar to current ones.

11.1 Shiraz plc

According to Modigliani and Miller (MM):

kEG=kEE+(kEE−kL)

where kEGis the cost of equity in the geared business, kEEthe cost of equity in the all-equity

business, kLthe cost of loan finance, LGthe value of loan notes in the geared business and

SGthe value of equity in the geared business.

Thus in the case of Shiraz plc:

20%=kEE+(kEE−10%)

1.583kEE=20% +5.833%

kEE=16.3%

£14m

(10m ×£2.40)

LG

SG

(£5.5m ×16.2%) +[£1.5m ×10% ×(1 −0.33)]

£5.5m +£1.5m

Chapter 11

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