Question

Fitness Training (FST) is a HK-based plc which produces gym equipment. Their business has grown quite quickly over the past few years and, as with most young companies in heavily capitalised industries, their only concern was if they had sufficient cash to continue to develop their operations. With stability and liquidity now being less of a concern the CEO of FST, is currently reviewing the company’s capital structure to gauge if they are structured in an appropriate way. By her own admission, she does not have much knowledge in this area and has asked for your help as an expert in the field of corporate financial management.

She has given you the following information:

Number of Ordinary shares in issue:                    20,000,000

Market Price per Ordinary share                          240 cents

Value of Current long-term debt                          HK$30,000,000

Gross Interest rate on long-term debt                  5% p.a.

Estimation of cost of equity                                  11% p.a.

Tax rate                                         20%

Required:

1. Calculate FST’s current after tax weighted average cost of capital.        

The CEO is keen to take on more debt as he has heard that “debt is always cheaper than equity.”

2. Using the information above evaluate this comment from both a practical and theoretical basis.                                      

Answer 1

Weighted Average Cost of Capital= 4.965517% calculated as below:

Debt is cheaper than equity for the following reasons:

(a ): Tax benefits: Interest paid is an allowable expenditure for tax purposes, in most of the counties. Hence debt financing will help in reducing the tax burden. This benefit is not available in equity financing.

In the given case, Cost of equity= 11% while after-tax cost of debt= 5%*(1-20%) = 4%

(b ): Cost of equity is the shareholders’ expectation of yield. This has attendant risks since the yield is not assured by contract. Hence the shareholders need higher yield to reward for the risk and hence higher cost. On the other hand, interest on debt is assured by agreement and hence less risky. Because of the risk reduction, cost is less.