Page 168 - Microsoft Word - 00 CIMA F1 Prelims STUDENT 2018.docx

Chapter 7

Example 1

X Co is identical in all operating and risk characteristics to Y Co, except that
X Co is all equity financed and Y Co is financed by equity valued at $2.1m and
debt valued at $0.9m based on market values. X Co and Y Co both operate in
a country where no tax is payable.

The interest paid on Y Co’s debt is $72,000 per annum, and it pays a dividend
to shareholders of $378,000 per annum. X Co pays an annual dividend of
$450,000.

Required:

(a) Calculate the value of X Co.

(b) Calculate the cost of capital for X Co.

(c) Calculate the cost of equity for Y Co, and the cost of debt for Y Co.

(d) Calculate the weighted average cost of capital for Y Co.

Solution

(a) V g = V u + TB, so given that T = 0,

V g = V u

so the value of X Co is the same as the value of Y Co, ($2.1m + $0.9m)
$3m

(b) Assuming no growth in dividends, using the dividend valuation model,

k eu = Dividend/V E = 450,000/3,000,000 = 15%

160