Question

Bruhaha Ltd (BL) is an Australian publicly listed firm on the ASX. The company has a long-term target capital structure of 50% ordinary equity, 10% preference shares, and 40% debt. All shareholders of BL are Australian residents for tax purposes.

To fund a major expansion BL Ltd needs to raise a $200 million in capital from debt and equity markets.

BL’s broker advises that they can sell new 10 year corporate bonds to investors for $105 with an annual coupon of 6% and a face value of $100. Issue costs on this new debt are expected to be 1% of face value.

The firm can also issue new $100 preference shares which will pay a dividend of $7.50 and have issue costs of 2%.

The company also plans to issue new ordinary shares at an issue cost of 2.5%. The ordinary shares of BL are currently trading at $4.50 per share and will pay a dividend of $0.15 this year. Ordinary dividends in BL are predicted to grow at a constant rate of 7% pa.

1. Calculate the total value and the quantity of debt BL will need to issue to maintain their target capital structure.
2. What will be the appropriate cost of debt for BL?   
3. Calculate the total value and quantity of preference shares BL will need to issue to maintain their target capital structure.
4. What will be the appropriate cost of preference shares for BL?   
5. Calculate the total value and quantity of ordinary shares BL will need to issue to maintain their target capital structure.   
6. What will be the appropriate cost of ordinary equity shares for BL?   
7. Calculate the Weighted Average Cost of Capital (WACC) for BL Ltd following the new capital raising.   
8. BL Ltd has a current EBIT of $1.3 million per annum. The CFO approaches the Board and advises them that they have devised a strategy which will lower the company’s cost of capital by 0.5%. How will this change the value of the company? Support your answer using theory and calculations.   

Please present all your workings including formulas.

Answer 1

Cost of bonds, kd

using the formula to find the present value,ie.current market Price of bonds,

Price/PV =PV of its future cash flows=PV of all its future coupon cash flows+PV of face value to be received at maturity----both discounted at the Yield or YTM--which is the before-tax cost of the bond

ie. Price /PV =(Pmt.*(1-(1+r)^-n)/r)+(FV/(1+r)^n)

where, price is taken as the net proceeds form bond issue, ie. 105-(100*1%)= $ 104

Pmt.= The annual   coupon in $ , ie. 1000*6= $ 60

r= the annual Yield ---before-tax annual cost to be found out----??

n= no.of coupon period still to maturity, ie. 10

FV= face value, ie. $ 100

So, plugging in these values in the formula,

ie. 104=(6*(1-(1+r)^-10)/r)+(100/(1+r)^10)

Solving the above , we get the before-tax annual cost of the bond as

5.47009%

Assuming the tax rate as 30%

After-tax cost of the bond=

Before-tax cost*(1-Tax rate)

ie. 5.47009%*(1-30%)

3.83%

Total value of debt to be raised= 200 mln.*40%= $ 80 mln.

& its after-tax cost= 3.83%

Total value of preference shares BL will need to issue = 200 mln.*10%= $ 20 mln.

and quantity of pref. shares= 20 mln./$ 100= 200000 pref. sahres

Cost of preference shares, kps

kps= $ dividend/Net proceeds of issue

ie. 7.50/(100*(1-2%))=

7.65%

Total value of ordinary shares BL will need to issue= 200 mln.*50%= 100 mln.

and quantity of ordinary shares =$ 100 mlns. /$ 4.50 per share, ie.

100000000/ 4.50=

22222222

shares

Cost of equity share , ke

as per constant growth . Dividend discount model

ke=(D0*(1+g)/Net proceeds)+g

ie. ke=(D1/P0*(1-issue costs))+g

ie(( 0.15*1.07)/(4.50*(1-2.5%))+7%=

10.66%

Now, the weighted average cost of capital(WACC)=

WACC=(wt.d*kd)+(wt,ps*kps)+(wt.e*ke)

ie.(40%*3.83%)+(10%*7.65%)+(50%*10.66%)=

7.63%

Value of the company with the current EBIT, ie EBIT 0, assuming the growth rate to be same as that of dividends , given as 7% p.a.--

at the above WACC of 7.63%

V0=Initial investment -EAT 1/(WACC-g), ie.(EBIT0*(1-Tax Rate)*1.07)/(WACC-7%)

ie.-200+((1.3*(1-30%)*1.07)/7.63%-7%))=

-45.444444

millions

IF the WACC is reduced by 0.5%, ie. 7.63%-0.5%=7.13%,then,

V0=Initial investment-EAT 1/(WACC-g)--ie.(EBIT0*(1-Tax Rate)*1.07)/(WACC-7%)

ie.-200+((1.3*(1-30%)*1.07)/(7.13%-7%))=

549

millions

So,

If the cost of capital is reduced by 0.5%--ie.from 7.63% to 7.13% ---Value(NPV of the investment decision) of firm increases & turns POSITIVE