Question

The following information has been extracted from the books of M & M limited company, an entity that is listed on the Exchange market, for the year ending December 2019.

CapitalComponent	Contribution [$]	Component       Cost(%)
$2 Ordinary Shares	2 000 000	34
Retained Earnings	800 000	34
$1 Cumulative Preference Shares	1 400 000	32
Convertible       Loan Notes	800 000	25
Total Financing	5 000 000

The convertible loan notes were issued two years ago at a face value of $5 000 but are currently trading at $6 250. Ordinary shares of the company are going for $4/share on the market with preference shares selling at $1.2/ share. The given cost of debt is before tax. The applicable corporate tax rate for the company is thirty percent. Answers correct to two decimal places or nearest percentage.

a) Determine both the book and market value weights of different capital components in the capital structure.                                                                                                             [6 marks]

b) Compute the after tax cost of debt.                                                                [2 marks]

c) Determine the return that the company’s projects should generate in order for the company to break even.                                                                                                                    [4 marks]

d) If the cost of capital does not change, what advice would you give to the company regarding a project proposal with a potential return of 27.5%/annum?                                                 [4 marks]

e) If normal capital gearing ratio for the industry is forty percent, what can be said about the company’s gearing? Show working and use market values.

Answer 1

Capital Component

Contribution

Cost

$ 2 ordinary shares

2000000

34

retained earnings

800000

34

$ 1 cumulative preferance shares

1400000

32

Convertible Notes

800000

25

Total Financing

5000000

Issue price of convertible notes

5000

Market price of convertible notes

6250

Ordinary share market price

4

Preference share market price

1.2

Tax rate

30%

A.

Number of convertible notes outstanding

convertible notes value in books/issue price

800000/5000

160 notes

Number of preferancw shares outstanding

Preference share capital/par value of preferance share

1400000/1

1400000 shares

Number of ordinary shares outstanding

oridinary share capital/par value of ordinary share

2000000/2

1000000 ordinary shares

Book value weight of ordinary share =

total shareholders fund / total financing

share capital + retained earnings/total financing

2000000+800000/5000000

56%

Similarly,

Book value weight of preference share =

1400000/5000000

28%

Book value weight of debt =

800000/5000000

16%

Market value of debt =

Market value per note x number of notes outstanding

6250 x 160

1000000

Similarly,

Market value of preference shares =

1.2 x 1400000

1680000

Market value of ordinary shares =

4 x 1000000

4000000

Total market value of the capital

1000000 + 1680000 + 4000000

6680000

Weight of debt =

Market value of debt / total market value of capital

1000000/6680000'

14.97%

Weight of preference shares =

1680000/6680000

25.15%

Weight of ordinary shares =

4000000/6680000

59.88%

B.

After tax cost of debt =

Interest rate x (1-tax rate)

25 x (1-0.3)

17.50%

C.

To breakeven a company should generate a return equal to its weighted average cost of capital (WACC)

To analyze a new project the weights based on the market value should be taken

WACC =

[weight of debt x cost of debt x(1-tax rate)] + [weight of preference share x cost of preference share] +[weight of ordinary shares x cost of ordinary shares]

[0.1497 x 25 x 0.7] + [0.2515 x 32] +[0.5988 x 34]

31.03%

D.

If a project's annual return is 27.5% per annum, it is less than the company's WACC and therefore should be rejected.

E.

Capital Gearing ratio =

(Market value of preference shares + Market value of debt)/Market value of equity

(1680000 + 1000000) / 4000000

67%

The company's capital gearing ratio is 67% which is much higher than the industry average of 40%. This means the company is highly leveraged and has a high portion of fixed payments. Due to this the financial risk of the comapny is pretty high and a fall in earnings may result in default and even bankruptcy. This also means that the future cost of capital would be higher due to the high financial leverage of the company. Please like the solution if satisfied and drop a comment in case of any doubt. Thankyou