Corvus Co: cost of capital and financing a project

Tick each point that your answer made clearly and only once. Points here are this site's own. A real examiner may accept other valid points.

• Cost of equity (CAPM) = 4% + 1.1 x (10% - 4%) = 10.6%.
• Market value of equity = 20 million x $3.00 = $60 million.
• Market value of the bonds = $30 million x 90% = $27 million.
• After-tax cost of the irredeemable bonds = 8 x (1 - 0.25) / 90 = 6.667%.
• After-tax cost of the bank loan = 7% x (1 - 0.25) = 5.25%.
• Total market value of finance = 60 + 27 + 10 = $97 million.
• WACC = (60 x 10.6% + 27 x 6.667% + 10 x 5.25%) / 97 = 8.95%.
• Market values, not book values (nominal values), are used for the weights.
• The bank loan's market value is taken as its carrying amount.

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Tick each point that your answer made clearly and only once. Points here are this site's own. A real examiner may accept other valid points.

• WACC can be used only if the project has the same business risk as the company and does not change its financial risk.
• The project is in a different industry, so its business risk differs, and the company's own WACC is not suitable.
• The listed company's beta of 1.4 can be used as a proxy (it has similar gearing, so it needs no adjustment).
• Project cost of equity = 4% + 1.4 x (10% - 4%) = 12.4%.
• A project-specific WACC would use this cost of equity with the project's financing mix and debt cost.
• Using the company's WACC could lead the company to accept projects with returns that are too low for their risk.

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Tick each point that your answer made clearly and only once. Points here are this site's own. A real examiner may accept other valid points.

• Islamic finance does not allow riba (interest). Returns are earned through trade, leasing or sharing in profit and loss.
• Ijara (lease finance): the financier buys the asset and leases it to the company for rentals.
• Murabaha (trade credit): the financier buys goods and sells them to the company at a mark-up, payable later.
• Sukuk (asset-backed securities) could raise a large amount by giving investors a share in the returns of the assets.
• Mudaraba or musharaka involve sharing profits and losses, so the cost depends on the project's performance and not on a fixed interest rate.
• The syllabus does not require calculations for these instruments.

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