1. To calculate the WACC for Company A and Company B, we will use the formula:
WACC = (Ke * E/V) + (Kd * (1 - T) * D/V)
Where:
Ke = Cost of equity
E = Market value of equity
V = Total market value of the firm (E + D)
Kd = Cost of debt
T = Tax rate
D = Market value of debt
For Company A:
E = R200,000 / 0.20 = R1,000,000
D = R120,000 / 0.12 = R1,000,000
V = R1,000,000 + R1,000,000 = R2,000,000
T = 1 (assuming full taxation)
WACC_A = (0.20 * 1,000,000 / 2,000,000) + (0.12 * 1,000,000 / 2,000,000) = 0.16
For Company B:
E = R432,000 / 0.18 = R2,400,000
V = R2,400,000 + 0 = R2,400,000
WACC_B = 0.18
2. To determine if shareholder X is adequately compensated for financial risk, we need to compare the return on equity (Ke) with the WACC.
Ke_A = 20% > WACC_A = 16%
Therefore, shareholder X is adequately compensated for financial risk in Company A.
3. To calculate the correct value for Company A shares, we can use the Gordon Growth Model:
Po = D1 / (Ke - g)
Where:
Po = Price of the share
D1 = Dividends = R200,000
Ke = Cost of equity = 20%
g = Growth rate
Assuming g = WACC_A = 16%
Po = R200,000 / (0.20 - 0.16) = R1,000,000
Therefore, the correct value for Company A shares is R1,000,000.
The following information for two companies which trade in a Miller and Modigliani world is provided:
Company A company B
Ke 20% 18%
Kd 12% -
Dividends R200 000 R432 000
Interest after Tax R120 000 -
Shares R1 000 R1 000
Investor X holds 100 shares in Company A.
Required:
1. Calculate the WACC for Company A and Company B. (10 Marks)
2. Determine if shareholder X is adequately compensated for financial risk. (10 Marks)
3. Calculate the correct value for company A shares, assuming that company B shares are correctly valued. (10 Marks)
1 answer