Question

17. XYZ LIMITED

	The following relates to XYZ Limited, a company listed on the London Stock Exchange:
		£m
	Assets Non-current assets	107.59
	Current assets	18.00
	Total assets	125.59
	Equity and liabilities Ordinary shares, nominal value 50c	40.00
	Retained earnings	26.00
	Total equity	66.00
	Non-current liabilities 7% bonds, redeemable at par in seven years' time	35.00
	Medium term bank loan	17.59
	Current liabilities	7.00
	Total equity and liabilities	125.59

Other relevant information:

Risk-free rate of return                   2%

Average return on the market        8%

Taxation rate                                 30%

XYZ Ltd.’s shares are currently being traded at £3.75 and it has an equity beta of 1.3.

XYZ Ltd.'s bank loan costs 8% per annum pre-tax, it is secured by a fixed charge on XYZ Ltd's Head Office. It is due to be repaid in five years' time.

The 7% bonds of the company are trading on an ex interest basis at £92.60 per £100 bond. It is secured by a general floating charge on XYZ Ltd's assets.

1. Using the market values as weights, calculate the weighted average cost of capital of XYZ Limited.

2. Discuss the differences in the cost of the different long-term finance used by XYZ Limited.

3.Discuss why using market value weighted average cost of capital is preferred to book value cost of capital when making investment decisions

Answer 1

1. For this, we first calculate the expected return on equity by the CAPM equation. Re = Rf + Beta(Rm-Rf)

Re = 2 + 1.3 x (8-3) = 8.5%. Now, we use the WACC formula, WACC = Rd x D/(D+E) x (1-T) + Re x E/(D+E)

The book value of the debt is = 92.6/100 x 35 = 32.41. So, debt ratio = D/(D+E) = 32.41/(66+32.41)= 33%. Equity ratio = 67%.

WACC = 8 x 0.33 x 0.7 + 8.5 x 0.67 = 7.543%.

2. The difference in the cost of financing for different options is because of the differences in risk in the financing options. Equity is riskier than debt and hence has a higher cost of financing whereas debt holders are the first ones to be paid. A convertible debt holder will lie in between the two in terms of risk and hence the cost of financing.

3. It is done because even though the book value figures are readily availabe,still Market Value WACC is considered appropriate by analysts because an investor would demand market required rate of return on the market value of the capital and not the book value of the capital.