Question

In: Finance

You are provided with the following information for ABC Book value structure Debenture ($100 per debenture)...

You are provided with the following information for ABC

Book value structure

  • Debenture ($100 per debenture)        $8 000 000
  • Preference shares ($100 per share)     $2 000 000
  • Ordinery shares ($10 per share)             $ 10 000 000

Recent market prices of all these securities are as follows

  • Debentures                          $110 per Debenture
  • Preference Shares               $120 per share
  • Ordinery shares                    $22 per share

External financial opportunities are:

  • $100 per debenture redeemable at par,10 year maturity,13% coupon rate, 4% floatation cost and sale price $100
  • $100 per preference share redeemable at par,10 year maturity,14% dividend rate,5% floatation cost and sale price $100
  • Ordinery shares: $2 per share floatation costs and sales price $22

Dividends expected on equity shares at the end of year is $2 per share, anticipated growth rate in dividends is 7%,ABC Ltd pats all its earnings in the form of dividends. Corporate tax rate is 30%

Calculate

  1. Cost of equity capital (3)
  2. Cost of preference shares (3)
  3. After tax cost of debt (4)
  4. Weighted Average Cost of Capital based on book values (5)
  5. Weighted Average Cost of Capital bases on market values (5)

Solutions

Expert Solution

a] Cost of equity capital = D1/(P0-f)+g, where,
D1 = Next expected dividend
P0 = Current share price
f = Flotation cost per share
g = Growth rate
Substituting available values,
Cost of equity capital = 2/(22-2)+0.07 = 17.00%
b] Cost of preference shares = YTM
YTM using an online calculator = 15% 15.00%
c] Before tax cost of debenture = YTM
YTM using an online calculator = 13.76%
After tax cost of debt = YTM*(1-t) = 13.76%*(1-30%) = 9.63%
d] Component Book Value Weight Component Cost WACC
Debt $          80,00,000 40.00% 9.63% 3.85%
Preference stock $          20,00,000 10.00% 15.00% 1.50%
Ordinary shares $      1,00,00,000 50.00% 17.00% 8.50%
Total $      2,00,00,000 13.85%
WACC based on book values 13.85%
e] Component Market Value Weight Component Cost WACC
Debt [8000000*110/100] $          88,00,000 26.51% 9.63% 2.55%
Preference stock [2000000*120/100] $          24,00,000 7.23% 15.00% 1.08%
Ordinary shares [10000000*22/10] $      2,20,00,000 66.27% 17.00% 11.27%
Total $      3,32,00,000 14.90%
WACC based on market values 14.90%

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