Question

Question 2 Weighted Average Cost of Capital

The capital structure of Minelli Enterprises Limited as at 31 March 2020 is as follows: $’000

Ordinary shares (par value $1.50) 60,000

5.5% (post-tax) Preference Shares (par value $2.20) 8,800

6.5% (pre-tax) Bonds semi-annual (par value $1000) 80,000

Term Loan (interest rate 4.25% per annum) 6,500

Additional Information:

• The ordinary shares are currently trading at $1.95 while the preference shares are trading at $2.45.

• Return on government bonds is 1.25%, the market risk premium 4.25%. A consultant has estimated the company to have a beta of 1.30.

• The company tax rate is 28%

• The bonds initially had a 5-year term to maturity and were issued exactly three years ago and would be redeemed at par.

• The current market value of the bond is $ 955.

Required:

2.1 Bond ratings are susceptible to the COVID-19 pandemic. Discuss.

2.2 Calculate the post-tax weighted average cost of capital (WACC) for Minelli Enterprises Ltd using the market valuation approach (show all workings).

Answer 1

2.1 Bond ratings are susceptible to COVID-19 pandemic as the pandemic may seriously impact the company's revenue and operating profit. The reduced economic activity due to the lockdowns, closures, and restrictions on movements has resulted in reduced income for most companies. Lower revenue decreases the debt service capacity of the companies and therefore, the bond ratings may be adversely impacted.

2.2 WACC

		Remarks
Bond value	8,00,00,000
par value	1,000
No of bonds	80,000	=bond value / par value
Coupon rate	6.5%
Market price	955
Yield	2.33%	=((1000/955)^0.5 )-1
Market value of bond	7,64,00,000	=955 * 80000
Term loan	65,00,000
Interest rate	4.25%
Ordinary shares value	6,00,00,000
Ordinary shares par value	1.50
No of shares	4,00,00,000	=share value / par value
Price per ordinary share (E )	1.95
Market value of ordinary shares	7,80,00,000	=1.95 * no of shares
Preference shares value	88,00,000
Preference shares par value	2.20
No of shares	40,00,000	=share value / par value
Price per preference share (PE)	2.45
Market value of Preference shares	98,00,000	=2.45 * no of shares
Debt (D )	8,29,00,000	bonds + term loan
Ordinary Equity (E )	7,80,00,000
Preference Equity (PE )	98,00,000
E+D+ PE	17,07,00,000	Total
D/(E+D+ PE)	0.49
E/(E+D+ PE)	0.46
PE/(E+D+ PE)	0.06
Risk free rate (Rf)	1.25%
beta	1.30
market risk premium (MRP)	4.25%
Re (Cost of ordinary equity)	6.35%	CAPM : Re = Rf + beta * MRP
Cost of preferred equity	5.50%
Cost of debt	2.48%	weighted avg of bond yield and term loan interest rate
Tax rate	28.00%
WACC	4.08%	=weight of debt * after-tax cost of debt + weight of equity * cost of ordinary equity + weight of preference equity * cost of preference equity