Question

3. The following information relates to the Fortescue Metals Group Ltd. Fortescue has 10,000 bonds outstanding with a face value of $1,000 each, which have 5 years to maturity and pays an-annual 10% coupon. The yield on the bonds is 10% p.a. Fortescue’s corporate tax rate is 30%. Fortescue has 5 million preference shares on issue, which are currently trading for $10.00 each, giving a total market value of $50 million. They pay an annual dividend of 50 cents per share. Fortescue has 7 million ordinary shares on issue, which are currently trading for $12.00 each. These shares are expected to pay an annual dividend of $1.00 next year, and this dividend is expected to grow at a constant rate of 2% in perpetuity.

a. What is Fortescue’s cost of debt?

b. What is Fortescue’s cost of preference share capital?

c. What is Fortescue’s cost of ordinary share capital?

d. What is Fortescue’s Weighted Average Cost of Capital (WACC)?

Answer 1

a
Cost of debt is its yield to maturity which is given as 10%
After tax cost of debt	Cost of debt*(1-tax rate)
After tax cost of debt	10%*(1-0.30)
After tax cost of debt	7.00%
b.
Cost of preference share capital	Dividend per share/Market price
Cost of preference share capital	0.50/10
Cost of preference share capital	5.00%
c.
Using the dividend growth model we can calculate expected return on stock
P0 = D0*(1+g)/(Ke-g)
P0 is the price today
D0 is dividend paid today
g is growth rate
Ke expected return on stock
12	1/(Ke-0.02)
12*(Ke-0.02)=1
12Ke - 0.24 = 1
12Ke = 1+0.24
Ke	1.24/12
Ke	10.33%
d.
WACC	Cost of equity*Weight of equity + Cost of preferred share*Weight of preferred share + Cost of debt*Weight of debt
Calculation of weight		Weights
Equity (7000000*12)	$84,000,000	58.33%	84000000/144000000
Preferred shares	$50,000,000	34.72%	50000000/144000000
Debt (10,000*1000)	$10,000,000	6.94%	10000000/144000000
Total market value	$144,000,000
WACC	(10.33%*58.33%)+(5%*34.72%)+(6.94%*7%)
WACC	6.03%+1.736%+0.49%
WACC	8.25%