Question

The directors of Surface Investment Limited have appointed you as their financial consultant. They are seeking new project investments and require you to calculate the present cost of capital of the company.
The capital structure is listed below:-
 2 million ordinary shares, with a par value of 50 cents each, currently trading at R4 per share. The company has a beta (ß) of 1.4, a risk free (Rf) rate of 9% and a return on the market (Rm) of 17%.
 1 million 13%, R2 preference shares, with a market value of R3 per share.
 R3 million 11%, debentures due in 5 years and the current yield-to-maturity is 8%.
 R900 000 16%. Bank loan, due in January 2021.
 The company also has a general reserve of R3 500 000 and a retained income of R4 000 000.
Additional information:
 The dividend growth of 12% per annum was maintained for the past 4 years. The latest dividend paid was 80 cents per share.
 The company has a tax rate of 30%.
Required:
2.1 Calculate the weighted average cost of capital. Use the Capital Asset Pricing Model to calculate the cost of equity. (19)
2.2 Calculate the cost of equity, using the Gordon Growth Model.

Answer 1

2.1 weighted average cost of capital :

CAPM Model to calculate the cost of Equity,

= 9% + 1.4( 17% - 9%) = 20.2%

Cost of preference shares:

= Coupon Payment / Current Value = (2 * 13%)/3 = 8.67%

Cost of debenture post tax :

To calculate this we need to calculate current price of the Bond = P  

= 8% * (1 - 0.3) = 5.6%

Current Price of Debentures P,

Solving for P gives = 112.50

So the current market value of Debentures = (112.5/100) * 3000000 = 3375000

Cost of bank loan (Post Tax) :

= 16% (1 - 0.3) = 10.2%

Cost of Equity	20.20%
Cost of preference shares	8.67%
Cost of debenture	5.60%
Cost of bank loan	10.20%

Source of Fund	Book Value	Market Value
Share	100000	8000000
retained income	4000000
general reserve	3500000
Equity	7600000	8000000
preference shares	2000000	3000000
debentures	3000000	3375000
Bank Loan	900000	900000
Total	13500000	15275000
Weightage	Book Value	Market Value
Equity	56.30%	52.37%
preference shares	14.81%	19.64%
debentures	22.22%	22.09%
Bank Loan	6.67%	5.89%

WACC	14.58%	14.12%
Multiplying each weightage associate their cost and summing up

So WACC as per Book Value 14.58% and Market Value = 14.12%

2.2 cost of equity, using the Gordon Growth Model

D = Latest Dividend = 0.80

g = Dividend growth rate = 12%

P = Latest Price of Share = 3

So, Cost of equity, using the Gordon Growth Model 41.86%