Question

In: Finance

The present capital sructure is as follows : 1.800,000 R2 ordinary shares now trading at r2,50...

The present capital sructure is as follows :

1.800,000 R2 ordinary shares now trading at r2,50 per share preference

2. 250,000 preference shares trading at r2 per share (isuued at R3 per share).10% fixed rate of interest.

3.Abank loan of R1 500,000 AT 13% p.a (payable over 5 years.

Additional data: the company's beta is 1.3. The return on the market is 14% and the risk fee rate is 7%.

its current tax rate is 28&. its current divided is 40c per share and it expects its dividends to grow by 8%.

You are required to : Assuming that the company uses the Sividend growth model to calculate its cost of equity. Calculate its weighted average cost of capital.

If a further R500,000 is needed to finance te expansion ,which option should they use from eitherr ordinary shares, preference share or loan financing and why?

Please help with the calculations and explain

Solutions

Expert Solution

MV of equity=Price of equity*number of shares outstanding
MV of equity=2.5*800000
=2000000
MV of Bond=Par value*bonds outstanding*%age of par
MV of Bond=1000*1500*1
=1500000
MV of Preferred equity=Price*number of shares outstanding
MV of Preferred equity=2*250000
=500000
MV of firm = MV of Equity + MV of Bond+ MV of Preferred equity
=2000000+1500000+500000
=4000000
Weight of equity = MV of Equity/MV of firm
Weight of equity = 2000000/4000000
W(E)=0.5
Weight of debt = MV of Bond/MV of firm
Weight of debt = 1500000/4000000
W(D)=0.375
Weight of preferred equity = MV of preferred equity/MV of firm
Weight of preferred equity = 500000/4000000
W(PE)=0.125
Cost of equity
As per DDM
Price = recent dividend* (1 + growth rate )/(cost of equity - growth rate)
2.5 = 0.4 * (1+0.08) / (Cost of equity - 0.08)
Cost of equity% = 25.28
After tax cost of debt = cost of debt*(1-tax rate)
After tax cost of debt = 13*(1-0.28)
= 9.36
cost of preferred equity
cost of preferred equity = Preferred dividend/price*100
cost of preferred equity = 0.3/(2)*100
=15
WACC=after tax cost of debt*W(D)+cost of equity*W(E)+Cost of preferred equity*W(PE)
WACC=9.36*0.375+25.28*0.5+15*0.125
WACC =18.03%

Choose bank loan for further financing as it has lowest cost : 9.36%


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