Question

During the past years, ABG had limited its investment plans due to high cost of capital. Recently, however, the cost of capital seems to have fallen, and the management of the company is seriously considering the implementation of two major investment plans. Assume that you are the assistant of the ABG's financial director, who has assigned you to calculate the company's cost of capital. Your financial manager has provided the following information:

1. The corporate tax rate is 20%.

2. The company has issued a total of 11,000 non-callable bond with 3% annual nominal interest rate, the coupon of which is paid to the bond holders every six months. These bonds expire after 5 years, have a par value of €1,000 and are currently being traded at €1,030.40.

3. The current price of ABG's preferred stock on the stock market is €3.4 and the company has issued a total of 834,000 shares. The preferences share has a par value of €1 and a 20% dividend yield upon the par value, distributed to the stockholders twice a year. In case of issuance of new preferred share capital, the issue and disposal costs will be €0.30 per share.

4. The current market price of ABG's common stock on the stock market is €3.7 and the company has issued 3,835,000 shares. ABG's most recent dividend (Do) was €0.22 per share and dividends are expected to grow at a steady 2% annual rate for the foreseeable future. The beta coefficient of ABG is 1.4, the long-term government bond offer investors a yield of 2%, and the Expected Return of the Market is estimated to be 6%.

To help you with your task, the Financial Manager of the company has asked you to answer the following questions:

a. What is the (pre-tax) cost of the ABG bond loan and what is the final, after tax, cost of the loan capital to be included in the estimation of ABG’s weighted average cost of capital?

b. What is the cost of the company's preferred share capital?

c. What is the cost of ABG's common equity capital using the Capital Asset Pricing (CAPM) model?

d. What is the cost of ABG's common equity capital, using the dividend discount model?

e. What is ABG's Weighted Average Cost of Capital (WACC)? (Assume that the cost of equity capital is the average value of the two methods of c and d)Explain whether the dividend policy of a company affects its value, by describing the various theories that have been put forward in the literature. Provide for each theory at least two references from published papers in scientific journals (approximately 1,000 words).

Answer 1

A.

No. of Non-callable bonds	11000
Par value	1000
Market Value	1030.4
Bond issue value	11000000
Tax rate	20%
Nominal annual interest rate (i)	3%

Effective annual interest rate (r) = (1 + i/n) ^{^n} - 1, where n is the no. of times compounding is done in an year. Here, n =2 since it is mentioned that bond interest is paid twice a year.

So, effective annual interest rate(r) = (1+ 3%/2)^{^2} - 1 = 3.0225%

This is the pre-tax cost of debt

Post-tax cost of debt = Effective annual interest rate * (1- Tax rate)

= 3.0225% * (1- 20%) = 2.42%

B.

No. of preference shares issued	834000
Price of stock	3.4
Par value	1
Total Market value	2835600
Total Par Value	834000
Dividend yield on par value	20%
Annual dividend per share (20% of $1)	$0.20
Issue and disposal cost per share	$0.30

Cost of preference capital = Annual dividend / Net proceeds after floatation costs(i.e.,Market price-floatation costs)

= $0.2 /($3.4-$0.3) = 6.452%

C.

No. of equity shares issued	3835000
Price of stock	3.7
Dividend at time 0 (D0)	0.22
Annual growth rate on dividend	2%
Beta coefficient (B)	1.4
Risk free return on Govt. bonds (RF)	2%
Expected return of market (ERM)	6%

As per CAPM model, cost of equity = Risk-free returns + Beta coefficient * (Expected return of market - Risk free return)

= 2% + 1.4 * (6% - 2%) = 7.60%

D. As per dividend discount model, cost of equity = (Dividend at time period 1 (D1) / Price at time period 0 (P0) ) + Growth rate on dividend (g)

So, here D1 = D0 * (1+g) = 0.22 * (1+2%) = 0.2244

Cost of equity =( 0.2244 / 3.7) + 2% = 8.06%

E. Cost of equity for WACC purpose = Average of two methods explained above = (7.60% + 8.06%) / 2 = 7.83%

Total market value of equity = No. of common stock * Market Price per share

= 3835000 * 3.7 = 14,189,500

Total market value of preferred stock = No. of preferred stoc * Market price per share

= 834000 * 3.4 = 2,835,600

Total market value of debt = No. of bonds * Market price per bond

= 11000 * 1030.40 = 11,334,400

Total market value of all three = 14,189,500 + 2,835,600 + 11,334,400 = 28,359,500

Percentage of each out of total market share = Total market share of respective security / Total market value * 100

Percentage of equity out of total	50.03%
Percentage of preferred stock out of total	10.00%
Percentage of debt out of total	39.97%

Weighted average cost of capital (WACC) = % of equity * Cost of equity + % of preferred stock * Cost of preferred stock + % of debt * After-tax Cost of debt

= (50.03% * 7.83%) + (10% * 6.452% ) + (39.97% * 2.42%)

= 5.5304%