ABMF2103 Principles of Finance

ACADEMIC YEAR 2021/22

Chapter 5: Capital Structure and Cost of Capital

TUNKU ABDUL RAHMAN UNIVERSITY COLLEGE

FACULTY OF ACCOUNTANCY, FINANCE AND BUSINESS

ABMF 2103 PRINCIPLES OF FINANCE

Tutorial: Chapter 5: Capital Structure and Cost of Capital

1) The following shows the balance sheet of KJK Bhd.

RM (‘000)
Account Payable 100
Accruals 150
Notes Payable 130
Total Current Liabilities 380

Long-term Debt (Bond) 1600

Total Liabilities 1980

Common stock equity 3000

Preferred stock equity 1500
Retained Earnings 2000
Total Equity 6500

Total Liabilities + Equity 8480

(a) Identify capital provided by investors of KJK Bhd.

(b) Calculate KJK Bhd capital structure.

 2) Explain why it is more appropriate to use the after-tax cost of debt than before-tax
cost of debt in the calculation of WACC.

Shareholders are interested in maximizing the value of the firm’s stock, and the
stock price depends on after-tax cash flows.

The interest payment is actually tax deductible. Have a tax savings .

3) Explain why retained earning has a cost.

Although there is no “ direct” cost paid on these retained earnings, however, retained
earnings still incur “opportunity cost”. Earnings can be either be distributed as
dividends or be reinvested, therefore if these earnings are retained, there exists an “
opportunity cost” which means the return that stockholders could earn on alternative
investments of equal risk.

shareholder can invest dividend to earn 7% on average, but the company retain the
earnings for futher investment, eg invest in futher project, the project must earn at least

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7% . then , shareholder will satisfied.

4) Explain pecking order theory in capital structure.

According to the pecking order hypothesis, companies should use retained

earnings, or internal financing, as the preferred option for raising capital.
Managers will decide how to raise capital, and they have a preferred order of
which to use first, followed by which. If retained earnings are not sufficient to
meet capital requirements, the company will issue new debt. If neither retained
earnings nor debt are sufficient, the last resort is to issue new common stock.

The reason why retained earnings are the preferred and best option for
companies is that there are no floating costs associated with using internal funds.
They are using their own funds and are not dependent on external investors. In
addition, because retained earnings are internal funds, it minimises asymmetry
because insiders and outsiders hold different information about the company. For
example, as the financial manager of your company, you will know the true risk
of your company. Perhaps your company is a low risk company, but outsiders
don't think so because they have less information and so they will charge a higher
rate than the company should pay. By using retained earnings, the problem of
information asymmetry can be reduced and you can avoid being charged more
than the company expects to pay, and therefore cheaper than external sources.

If retained earnings are insufficient and the company has to raise funds
from external sources, it should issue new debt because the cost of issuing new

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debt is relatively low. In addition, issuing new debt is usually seen as a positive
sign by the market as it indicates that the company is confident in its ability to
service its debt in the future. If a company is not confident in issuing debt, then
they will not borrow any debt as regular payments that cannot be met will lead to
bankruptcy.

As issuing new shares incurs higher float costs, companies should issue
new common shares as a last resort. In addition, there is a 'signalling effect' when
a company decides to issue new ordinary shares. The market perceives the
issuance of new common shares as a negative signal that the company's shares are
overvalued and that the company is taking advantage of its relatively high market
price to sell new shares. Investors will immediately sell shares that they believe
have a higher market price than the true price of the stock for a profit, because
one day the market price will fall to equal or even be lower than the true price.
For example, if a company suddenly sells common shares, investors may think
that the company is selling at a high price because they do not know the true price
of the stock and investors can only go by their estimates, but the company knows
the true price. Therefore, investors will follow the company's decision to sell the
shares, so the share price will drop. If the company sells new common shares at a
market price of RM15 and the investors' estimate of the true price is RM10, this
indicates that the company's shares are overvalued and they will sell the shares for
a profit. Empirical studies have shown that more often than not, when a company
announces a new share issue, its share price will fall.

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5) Victory Bhd has a target capital structure of 30% debt and 70% common equity,
with no preferred stock. The yield to maturity on the company’s outstanding
bonds is 9%, and its tax rate is 25%. Victory’s CFO estimates that the company’s
WACC is 10.50%. What is Victory’s cost of common equity?

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6) Millionaire Corporation has a target capital structure of 55 percent common stock,
10 percent preferred stock, and 35 percent debt. Its cost of equity is 12 percent,
the cost of preferred stock is 7 percent, and the cost of debt is 9 percent. The
relevant tax rate is 25 percent. Find Millionaire’s WACC.

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7) The UC Bhd ’s common stock has a beta of 1.4. If the risk-free rate is 4% and the
expected return on the market is 13%, what is the company’s cost of equity
capital?

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8) The KJK Bhd ’s currently outstanding bonds have an 7% coupon and a 11% yield
to maturity. KJK believes it could issue new bonds at par that would provide a
similar yield to maturity. If its marginal tax rate is 25%, what is KJK after-tax
cost of debt?

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9) Besides, KJK Bhd can issue perpetual preferred stock at a price of RM60.00 a
share. The stock would pay a constant annual dividend of RM7.00 a share. What
is KJK’s cost of preferred stock?

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10) Next, KJK Bhd is expected to pay a RM2.50 per share on its common stock. The
company is expected to maintain a constant 5.5 percent growth rate in its
dividends indefinitely. If the stock sells for RM52 a share, what is the company’s
cost of equity?

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11) Given that KJK’s target capital structure is 40% equity, 40% debts and 20%
preferred stocks. Calculate KJK’s WACC.

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