Question

Osama Co. is a listed company operating in the textile industry. Osama Co’s board of directors met recently to discuss a new strategy for the business. The proposal put forward was to sell all the old plant and machinery and use this fund as well as borrow from market to purchase new plant and equipment. The new plant and machinery are more productive and meet the current standard quality required by the international buyers. It is also argued that new plant is more energy efficient and environment friendly that gives more advantage when facing international competitors.

The proposal stated that the funds raised from the sale of the old plant and machinery would be used to buy the new plant and machinery.

New borrowing for the balance amount will be made from local bank which offered lowest rate. Since inflation is on higher side compared to last few years so cost of borrowing is on higher side which will increase firm cost of capital.

The board of directors are of the opinion that increasing the level of debt in OSAMA Co. will increase the company’s risk and therefore it can increase its cost of equity capital. It is assumed that due to change in plant and equipment current local sales of the product will not be affected.

New Plant price                                  Rs.5.32 million

Sales of old plant                                Rs.1.32 million

Firm existing capital structure i.e. debt to assets ratio is 40:60.

At this level firm interest rate on all debt is 9.5%.

After borrowing firm capital structure will shift to 60:40 and at this level firm beta will shift from earlier 1.2 to 1.4. Risk free rate of return is 7% and market risk premium is 6%. New loan is negotiated with HBL bank and it is agreed that this loan will be for five years at 11% mark up.

Instructions:

1. How much borrowing required by firm?
2. Why risk factor will increase if firm is changing its capital structure?
3. What is the current weighted average cost of capital?
4. What the new cost of equity capital?
5. What would be new Weighted Average Cost of Capital?

Answer 1

1-	How much borrowing required by firm?	cost of new house-sale proceeds from sale of old house	5.32-1.32	4
2-	due to use of excess debt, leverage ratio of the company will change and credit risk will increase due to which equity investors will demand more return on equity.
cost of equity	risk free rate+(market risk premium)*beta	7%+(6%)*1.2	14.20%
3-	WACC
source	weight	component cost of capital	weight*component cost of capital
debt	40%	9.50%	3.800%
equity	60%	14.20%	8.520%
WACC = sum of weight*component cost of capital			12.320%
4-
cost of equity	risk free rate+(market risk premium)*beta	7%+(6%)*1.4	15.40%
new cost of debt	current cost of debt*(1+mark up rate)	9.5*1.11	10.55
5-	WACC
source	weight	component cost of capital	weight*component cost of capital
debt	60%	10.55%	6.327%
equity	40%	15.40%	6.160%
WACC = sum of weight*component cost of capital			12.487%