Question

Sheffield Manufactures Ltd, operate in the printing and packaging industry. They feel that some of their older printing and labelling machines need to be replaced. They seek help in order to calculate their cost of capital. Their present capital structure is as follows: • 800 000 R2 ordinary shares now trading at R2.50 per share. • 250 000 preference shares trading at R2 per share (issued at R3 per share), at 10% fixed rate of interest. • A bank loan of R1 500 000 at 13% p.a. (payable in 5 years’ time) Additional data a. The company’s beta is 1.3. the return on the market is 14% and the risk free rate is 7% b. Its current tax rate is 28% c. Its current dividend is 40c per share and it expects its dividends to grow by 8% p.a. Required 1.1 Assuming that the company uses the Dividend Growth Model to calculate its cost of equity. Calculate its weighed average cost of capital. (17) 1.1.1 If a further R500 000 is needed to finance the expansion, which option should they use from ordinary shares, preference shares or loan financing and why? (3)

Answer 1

Costs of Capital

• First Alternative:
  Price of share being R2.50 = (Dividend of next year) / (Cost of ordinary shares - Growth rate)
  That is, R2.50 = (40c+8% of 40c) / (Cost of ordinary shares - 8%).
  Solving it: 43.20c / R2.50 = Cost of ordinary shares - 8%
  Cost of ordinary shares = 25.28%
  Second Alternative:
  Cost of ordinary shares = Risk free rate + Beta x (Market Return - Risk free rate)
  That is, 7% + 1.3 x (14% - 7%)
  That is, 16.1%
• Cost of preference shares = 10% x 3/2 = 15
• Cost of debt = 13% x 1-28% = 13% x 72% = 9.36%

Weighted Average Cost of Capital

• If price of share = R2.5, then cost of ordinary shares = 25.28%, and then Total value = R4,000,000 [being (800,000 x 2.5) + (250,000 x 2) + (1,500,000)]
• If cost of ordinary share = 16.1%, then price of share = 43.20c / 16.1% - 8% = R5.33; then Total value = R6,264,000 [being (800,000 x 5.33) + (250,000 x 2) + (1,500,000)

Table for First alternative:

Particulars	Cost	Weight	Weighted Average Cost [Cost x Weight]
Ordinary Shares	25.28%	2,000,000/4,000,000 = 50%	12.64%
Preference Shares	15%	500,000/4,000,000 = 12.5%	1.875%
Debt (Bank Loan)	9.36%	1,500,000/4,000,000 = 37.5%	3.51%
TOTAL			18.025%

Table for Second Alternative:

Particulars	Cost	Weight	Weighted Average Cost [Cost x Weight]
Ordinary Shares	16.1%	4,264,000/6,264,000 = 68.07%	10.96%
Preference Shares	15%	500,0006,264,000 = 7.98%	1.20%
Debt (Bank Loan)	9.36%	1,500,000/6,264,000 = 23.95%	2.24%
TOTAL			14.40%

ANSWER TO REQUIREMENT 1.1: [First alternative] The Weighted average cost of capital works out to 18.025% (it may be rounded up to 18.03%).
ANSWER TO REQUIREMENT 1.1: [Second alternative] The Weighted average cost of capital works out to 14.40%.

[Note: Other viewpoints exist, but these appear to be the most appropriate. If your book teaches a different way, kindly mention, and I will explain based on that].

ANSWER TO REQUIREMENT 1.1.1: If they need additional R500,000, it is advised to go for further bank loan at the same rates, based on our calculations, because it costs 9.36% after tax, whereas the other two modes of capital costs higher than 9.36%.

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