Question

Part B Cost of Capital (Show all workings 50 marks) Grainwaves Ltd is an Australian firm which is publicly-listed on the ASX. The company has a long term target capital structure of 55% Ordinary Equity, 5% Preference Shares, and 40% Debt. All of the shareholders of Grainwaves are Australian residents for tax purposes. To fund a major expansion Grainwaves Ltd needs to raise a $150 million in capital from debt and equity markets. Grainwaves Ltd’s broker advises that they can sell new 10 year corporate bonds to investors for $105 with an annual coupon of 6% and a face value of $100. Issue costs on this new debt is expected to be 1% of face value. The firm can also issue new $100 preference shares which will pay a dividend of $7.50 and have issue costs of 2%. The company also plans to issue new Ordinary Shares at an issue cost of 2.5%. The ordinary shares of Grainwaves are currently trading at $4.50 per share and will pay a dividend of $0.15 this year. Ordinary dividends in Grainwaves are predicted to grow at a constant rate of 7% pa. i. Calculate how much debt Grainwaves will need to issue to maintain its target capital structure. ii. What will be the appropriate cost of debt for Grainwaves. iii. Calculate how much Preference Share equity Grainwaves will need to issue to maintain their target capital structure. iv. What will be the appropriate cost of Preference shares for Grainwaves? v. Calculate how much Ordinary Share equity Grainwaves will need to issue to maintain their target capital structure. vi. What will be the appropriate cost of Ordinary Equity shares for Grainwaves? vii. Calculate how the Weighted Average Cost of Capital for Grainwaves Ltd following the new capital raising. viii. Grainwaves Ltd has a current EBIT of $1.3 million per annum. The CFO approaches the Board and advises them that they have devised a strategy which will lower the company’s cost of capital by 0.5%. How will this change the value of the company? Support your answer using theory and calculations.

Answer 1

i]

Debt to issue to maintain its target capital structure = capital required * target debt ratio = $150 million * 40% = $60 million

ii]

cost of debt is the after-tax yield of the bonds

Before-tax yield is calculated using RATE function in Excel :

nper = 10 (10 years to maturity with 1 annual coupon payment each year)

pmt = $100 * 6% (annual coupon payment = face value * coupon rate. This is entered as a negative number because it is a cash inflow to the buyer of the bond)

pv = - 104 (issue price of bond, net of issue cost. Issue cost = 1% of $100, which is $1.  This is entered as a positive number because it is a cash outflow to the buyer of the bond)

fv = 100 (face value of bond. This is entered as a negative number because it is a cash inflow to the buyer of the bond)

RATE is calculated to be 5.47%

The tax rate is assumed to be 30%

After-tax yield = 5.47% * (1 - tax rate) = 5.47% * (1 - 30%) = 3.83%

cost of debt = 3.83%

iii]

Preference equity to issue to maintain its target capital structure = capital required * target preference equity ratio = $150 million * 5% = $7.5 million

iv]

cost of Preference shares = preference dividend / net issue price of preference shares

net issue price of preference shares = $100 - (2% of $100) = $98

cost of Preference shares = $7.50 / $98 = 0.0765, or 7.65%