Question

james PLC one of the companies listed on the stock exchange wishes to calculate its updated weighted Average cost of capital for use in the investment appraisal process.

$'

Million

Issued shared capital ($100 shares 2,000

Share premium 1,300

Reserves 145

Share Holders funds 3,445

6% irredeemable Debentures 1,400

9% Redeemable Debentures 1,450

Bank loan 500

Total Long - Term liabilities 3,350

The current cumulative interest market value per $100 units is $103 and $105 for the 6% and 9% debentures respectively. The 9% denture is redeemable at par in 10 years' time. The bank loan bears interest rate of 2% above the base rate (current base rate is 15%). The current ex-div market price of shares is $1,100 and a divided of $100 per share which is expected to grow at a rate of 5% per year has just been paid. The effective corporation tax rate for James PLC is 30%.

Required

(a) Calculate the effective after tax Weighted Average cost of Capital (WACC) for James PLC.

(b) Using the traditional theory of capital structure explain what would happen if the company took on additional debt finance.

  

Answer 1

Wacc formula = (Equity weight× cost of equity)+(Debt weight ×cost of debt)

Equity weight= total equity/total long term liabilities+equity

3445/6795

50.7%

Debt weight = totalmente/total ling term liabilities+equity

3550/6795=49.3%

Cost of equity= dividend/equity

Dividend =100×105%=105 per share

Cost of equity=105/2000=5.25%

Cost of debt= total interest/ total debt

=103+105+76.5(500×15.3%)

284.5/3350=8.5%

WACC=(8.5×1-0.3)×49.3%+(50.7×5.25%)

=(5 .95%×49.3)+(5.25%×50.7)

5.59%

WACC is 5.59%

B)The traditional approach to capital structure assumes that an increase in the proportion of debt to some extent does not result in an increase in the cost of equity, i.e., it remains fixed or grows slightly. That is the reason why it becomes possible to reduce the weighted average cost of capital I.e WACC  by increasing the proportion of debt financing in total capital. Thus, firms using financial leverage within certain limits are valued higher by the market than similar companies with lower financial leverage.

If the company took more equity then the weighted cost of debt will increase that will not be an optimal ratio and mix of the company. More debt will not give good results to the company growth as per traditional method.