Question

Question 3 [20 marks]

Western Mining has debt outstanding of $300 million in market value, consisting of 7% coupon bonds with a maturity of 10 years. The bonds pay semi-annual coupons with a face value of $1,000 and priced at $1,024.87 each. The company also has 2 million preference shares outstanding with a market price of $20 each, paying an annual dividend of $1.05. It has 14 million ordinary shares outstanding, priced at $21.00 a share. The company is expected to pay a $1.20 ordinary dividend 1 year from today, and future dividend is expected to increase by 7% per year forever. The relevant corporate tax rate is 30%.

a. Discuss the key steps required to estimate the company’s weighted average cost of capital .

b. Calculate the after-tax cost of each of the company’s current financing sources .

c. Using the information provided, calculate the market values for the financing sources for the company .

d. Using the information from b.) and c.) calculate the company’s after-tax weighted average cost of capital. If the investors' expected return is 14% per year, is the company creating additional wealth for the shareholders? .

Answer 1

Ans a.

The key steps for finding the WACC are

1. Find the after tax cost of Debt and cost of

Preference shares and common equity

2. Find the Market value of each source of

capital.

3. Find the Weight of each capital source in

total capital.

4. Find WACC by multiplying the cost of capital with

the respective weight of the capital and summing

those up.

Ans b.
Cost of Debt :
Given
Face value of Bond	$                       1,000
Market Price of Bond	$                 1,024.87
Annual Coupn amount @7%	$                       70.00
Year to Maturity =n=	10
We need to Find the Yield to Maturity
YTM = [ Annual Interest +(Face Value-Market Price)/Years to maturity]/(Face value+2.Maketvalue)/3
YTM =[70+(1000-1024.87)/10]/(1000+2*1024.84)/3
YTM =6.65%
Tax rate =30%
Post Tax cost of Debt =6.65%*(1-30%)=4.66%

Cost of Preference share :
Annual Prefernce dividend	$1.05
Market Price per Pref Share	$                       20.00
Cost of Pref Share =1.05/20=	5.25%
Cost of Common Equity :
Next Year Dividend =D1=	$                         1.20
Dividend growth rate =g=	7%
Assume Cost of Equity =k
Price per share =P0=$21
Now : P0=D1/(k-g)
21=1.2/(k-0.07)
k=12.71%
So Cost of Equity =12.71%

Ans c.
Market Value of Financial sources
Source of Capital	No Outstanding	Market price/share	Total Market value
Debt			$ 300,000,000
Preference share	2,000,000	$                         20.00	$     40,000,000
Common Share	14,000,000	$                         21.00	$ 294,000,000
		Total	$ 634,000,000

Ans d.
Calculating WACC
Source of Capital	Total Market value	% weight Market Value	Post Tax cost	Weighted cost
Debt	$           300,000,000	47.32%	4.66%	2.21%
Preference share	$             40,000,000	6.31%	5.25%	0.33%
Common Share	$           294,000,000	46.37%	12.71%	5.89%
Total Value	$           634,000,000	100%		8.43%
So WACC = 8.43%
If investors expect 14% pa return, the Company cas create additional wealth for investors as its weighted average cost
is lower than the investor's required return rate .