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Hello John,
I have a question regarding problem 158 from Kaplan exam kit:
Summary financial statements are given below for JE, the division of a large divisionalised company:
Balance Sheet
Non current assets 2400
Current asstes 1000
Total assets 3400
Divisional equity 1500
LT borrowings 900
Current liabilities 1000
Total equity and liabilities 3400Income Statement
Revenue 7300
Operating costs 6800
Operating profit 500
Interest paid 320
Profit before tax 180The cost of capital for the division is estimated at 11% each year. The annual rate of interest on the LT loans is 9%. All decisions concerning the division’s capital structure are taken by central management.
What is the divisional residual income for the year ended 31 December?
What I have done is:
RI = 500 – 1500*11%-900*9%=254
The solutions are indicating on the other hand RI = 500 – 2400*11% = 236.
How can the cost of capital be applied to debt when it has its own separate cost of 9%? Why aren’t they taking that into the account? Furthermore, it does not say that 11% is the Weighted Average Cost of Capital – then applying the 11% on the whole lot would make sense to me…
Please help me to clarify.
Many thanks in advance
Regards
MarkoKaplan should not have this in their exam kit because weighted average cost of capital is not examinable in Paper F5 and therefore cannot be mentioned.
However, using 11% is correct. The cost of capital to a company is always the weighted average cost of capital – it is made up of the cost of the long-term debt together with the cost of equity (which will always be higher).
Again, Kaplan should not have introduced this confusion because it is not relevant for F5.
John,
I did not seem to understand your point. I understood that you are saying that mentioning interest on debt implicitly introduced the topic of WACC but how can applying 11% be correct then of you are saying the rate should always be WACC, and the 11% is not the WACC in this case… Please help me understand.
Thanks
Best
MarkoI did not say that at all!
I said that the cost of capital is always the weighted average cost of capital, and the question says that the cost of capital is 11%.
Applying 11% is correct.
But yet again, any discussion of the cost of capital and its calculation is not relevant until paper F9.
Thanks John!
The question remains confusing the way it is written and I would always write the answer that I wrote originally. It seems negligent to me to disregard the loan interest rate of 9% and apply 11% to this portion as well. I suppose I would be awarded some if not all of the marks for my answer 🙂
Thank you again!
Your support is priceless
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