The following financial information relates to the operations of Graeson’s
Boats Ltd. Emmy Lou Ltd. is planning to expand its operations in the fishing
industry and is viewing Graeson’s Boats Ltd. as a possible acquisition.
The following figures have been extracted from Graeson’s Boats Ltd
accounts.
Statement of Financial Position
as at 30 June 2002
$000
Current assets 14,000
Investments 11,000
Non Current assets 20,000
45,000
Current liabilities (non-interest bearing) 11,700
Debentures 11,300
Reserves 9,000 Share Capital (Issued at $1) 13,000
45,000
Additional information
i Government bonds are currently yielding 6% per annum.
ii The current market return on equity is estimated to be 14% per annum.
iii A merchant banker suggests that Graeson’s Boats Ltd would have to
offer a rate of 11% p.a. on any new issue of 10 year debentures.
iv The current $1,000 debentures have a coupon rate of 9%,
compounded semi annually, with ten years to maturity.
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v The company tax rate is 30%.
vi Graeson’s Boats Ltd shares have recently traded at $4 and the
company’s financial manager believes that a beta of 1.5 is appropriate
to the company.
a) Estimate the cost of capital for Graeson’s Boats Ltd.
Source Market
Value
Weight Cost % WACC %
(1) (2) (3) (4) (3)x(4)
Debentures 9949606
16.06% 7.7 1.24
Ord Shares 52000000 83.94% 18 15.11
61949606 100.00 16.35
WACC =16.35%
b) Explain what this rate means and identify the key factors which may
influence its usefulness
It is the firm’s overall cost of capital. It is the overall return that the firm
must earn on its existing assets to maintain the value of its shares. It is
the discount rate that we use to evaluate a proposed expansion.
Problems
• Divisions must have similar risk profiles
• Proposed projects must have a similar risk as the firm
• Costs of raising funds are ignored