CALCULATE HUJU\'S COST OF EQUITY AND WEIGHTED AVERAGE COST OF CAPITAL BEFORE AND

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CALCULATE HUJU'S COST OF EQUITY AND WEIGHTED AVERAGE COST OF CAPITAL BEFORE AND AFTER IMPLEMENTING THE PROPOSAL, TAKING INTO CONSIDERATION ANY ASSUMPTIONS

10. HUJU is a listed company operating in the hospitality and leisure industry. HUJU's board of directors met recently to discuss a new strategy for the business. The proposal put forward was to sell all the hotel properties that HUJU owns and rent them back on a long term rental agreement. HUJU would then focus solely on the provision of hotel services at these properties under its popular brand name. The proposal stated that the funds raised from the sale pf the hotel properties would be used to pay off 70% of the outstanding non- current liabilities and the remaining funds would be retained for future investments. The BODs are of the opinion that reducing the level of debt in HUJU will reduce the company's risk and therefore its cost of capital. If the proposal is undertaken and HUJU focuses exclusively on the provision of hotel services, it can be assumed that the current market value of equity will remain unchanged after implementing the proposal. Extract from the most recent Statement of Financial Position RM C000) 42.560 26,840 69,400 Non-current assets (revalued recently) Current assets Share capital (RM0.25 per share par value) Reserves Non-current liabilities (5.2% redeemable bonds. RM100 nominal value) Current liabilities 3,250 21.780 42,000 2,370 69,400 HUJU's latest free cash flow to equity of RM2.6 million was estimated after taking into account taxation, interest and reinvestment in assets to continue with the current level of business. It can be assumed that the annual reinvestment in assets required to continue with the current level of business is equivalent to the annual amount of depreciation. Over the past few years, HUJU has consistently used 40% of its free cash flow to equity on new investments while distributing the remaining 60%. The market value of equity calculated on the basis of the free cash flow to equity model provides a reasonable estimate of the current market value of HUJU. The bonds are redeemable at par in three years and pay the coupon on an annual basis. Although the bonds are not traded, it is estimated that HUJU's current debt credit rating is BBB but would improve to A+ if the non-current liabilities are reduced by 70%. HUJU's current equity beta is 1.1 and it can be assumed that debt beta is 0. The risk-free rate is estimated to be 4% and the market risk premium is estimated to be 6%. There is no beta available for companies offering just hotel services, since most companies own their own buildings. The average asset beta for property companies has been estimated at 0.4. It has been estimated that the hotel services business accounts for approximately 60% of the current value of HUJU and the property company business accounts for the remaining 40%. HUJU's corporation tax rate is 20%. The three-year borrowing credit spread on A+ rated bonds is 60 basis points and 90 basis points on BBB rated bonds, over the risk free rate of interest Calculate HUJU's cost of equity and weighted average cost of capital before and after implementing the proposal, taking into consideration any assumptions

Explanation / Answer

At intial stage Company bond is under BBB category and Beta of bond is 0

so, interest rate = risk free + 90 basis point = 4+0.90 = 4.90

For equity , Beta=1.1, risk free= 4% , Market return = risk free rate + risk premium = 4 + 6 = 10%

after implimentation of proposal ,

Beta = 0.4*60% + 1.1 *40% = 0.68 for equity and other factors remain same .

under A+ category and Beta of bond is 0

so, interest rate = risk free + 60 basis point = 4+0.60 = 4.60

Cost of Equity Riskfree rate 4.00% Beta 1.10 Market return 10.00% Cost of Equity 10.60% Cost of Debt Rate 4.90% Taxrate 20% Cost of Debt 3.92% WACC 10.05%

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