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

1) Let's calculate Book Value of Weights of given components:

Book Value of ordinary Shares(Common shares)=$2,000,000

Book value of preferred shares=1,400,000

Book Value of retained earnings=$800,000

Book value of convertible notes(Loan)=$500,000

Weights of mentioned components:

Wc=2,000,000/(2,000,000+1,400,000+800,000+800,000)=0.40

Wps=1,400,000/(2,000,000+1,400,000+800,000+800,000)=0.28

Wre=800,000/(2,000,000+1,400,000+800,000+800,000)=0.160

Wd=800,000/(2,000,000+1,400,000+800,000+800,000)=0.160

Now let's calculate weights of these components ar market value:

Market Value of ordinary Shares(Common shares)=$2,000,000/2*4=4,000,000

Market value of preferred shares=1,400,000*1.2=1,680,000

MarketValue of retained earnings=$800,000

Market value of convertible notes(Loan)=$800,000/5000*6250=1,000,000

Weights as per market value:

Wc=4,000,000/(4,000,000+1,68,000+800,000+1,000,000)=0.535

Wps=1,68,000/(4,000,000+1,68,000+800,000+1,000,000)=0.225

Wre=800,000/(4,000,000+1,68,000+800,000+1,000,000)=0.107

Wd=1,000,000/(4,000,000+1,68,000+800,000+1,000,000)=0.134

2) After cost of debt=25%*(1-0.30)=17.50%

WACC=Wc*Kc+Wps*kps+Wre*Kre+wd*kp*(1-t)

WACC=0.535*.34+0.225*.32+0.107*.34+.134*.25*(1-0.30)

WACC=31.34%

Assuming this is the minimum required rate of return the company is expecting from the project.

3) As return of 27.75 % is less than the WACC calulated, the comlany should not go for the project as the least return is 31.34%

4) Capital gearing ratio=fixed interest cost funds/shareholder's equity

Capital gearing ratio: 1,000,00/(4,000,000+1,680,000+800,000)=28.74%

AS industry's gering ration is 40%, the company is comfortable in it's leverage as compared to it's equity.