Question:

(a) As the cost of capital is an essential element of investment appraisal, its calculation must be undertaken with care. Failure to do so could lead to adverse consequences for the business.

Required:

Explain clearly the adverse consequences which could result from failing to calculate correctly the cost of capital for a business?

(b) The dividend-based approach or dividend valuation model used to determine the cost of ordinary shares to a business takes into account the expected dividend stream over the whole life of the business.

Required:

Explain whether this approach is really relevant for an investor who holds a share for a particular period of time (say five years) and then sells the share.

(c) An ordinary share has a current market value of Rs 96, and the last dividend was Rs 12. The expected growth rate of dividends is 4 % per annum.

Required:

Calculate the cost of equity capital.

(d) Wait Ltd has ordinary share capital with a market value of Rs 4.5m and a cost of 20 % per annum. It has debentures with a market value of Rs 1.5m and a cost of 10 % per annum.

Required:

Calculate the weighted average cost of capital.

(e) State the assumptions made behind the use of the weighted average cost of capital as an NPV discount rate