Question

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

Answer 1

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%