Question

Allione plc is trying to decide on a cost of capital to apply to the evaluation of investment projects. The company has an issued share capital of 600,000 ordinary K1 shares, with a current market value cum-div of K1.18 per share. It has also issued K300,000 of 10% debentures, which are redeemable at par in five years’ time and have a current market value of K105.30 cum-interest, and K100,000 of K1 irredeemable 6% preference shares, currently priced at K0.40 per share ex-div. The preference dividend has just been paid, and the ordinary dividend and debenture interest are due to be paid in the near future. Management considers the current capital structure of the company to be similar to their plans for its long-term capital structure. The ordinary share dividend will be K50,000 this year, and the Directors have published their view that earnings and dividends will increase by 5% a year into the indefinite future. The company pays tax at 25% per year in the same year as profits.

Required:

a) Calculate the WACC.

b) Discuss the importance of the cost of capital in project appraisal and highlight the impact that a wrong discount rate would have on decision making.

Answer 1