Question

Sakura PLC is a leading investment company in Australia and you the below details relating to the capital structure of the company.
Information concerning raising new capital
Bonds
$1,000
Face value
13%
Coupon Rate (Annual Payments)
20
Term (Years)
$25
Discount offered (required) to sell new bonds
$10
Flotation Cost per bond
Preference Shares
11%
Required rate to sell new preference shares
$100
Face Value
$3
Flotation cost per share
Ordinary Shares
$83.33
Current Market Price
$4.00
Discount on share price to sell new shares
$5.40
Flotation Cost per bond
$5.00
2019 - Proposed Dividend
Dividend History
$4.63
2019
$4.29
2018
$3.97
2017
$3.68
2016
$3.40
2015
Current Capital Structure
Extract from Balance Sheet
$1,000,000
Long-Term Debt
$800,000
Preference Shares
$2,000,000
Ordinary Shares
Current Market Values
$2,000,000
Long-Term Debt
$750,000
Preference Shares
$4,000,000
Ordinary Shares
Tax Rate
33%
Risk Free Rate
5%
3
a) Calculate the cost associated with each new source of finance. The firm has no retained earnings available.
b) Calculate the WACC given the existing weights
The financial controller does not believe the existing capital structure weights are appropriate to minimise the firm’s cost of capital in the medium term and believes they should be as follows
Long-term debt 40%
Preference Shares 15%
Ordinary Shares 45%
c) What impact do these new weights have on the WACC?
The firm is considering the following investment opportunity. (2020-2027)
Data is as follows
Initial Outlay
$1,600,000
Upgrade
$700,000
End of Year 4
Upgrade -
350,000
Increased sales units per annum - (Year 5-8)
Working Capital
$45,000
Increase required
Estimated Life
8
Years
Salvage Value
$60,000
Depreciation Rate
0.125
For tax purposes
The machine is fully depreciated by the end of its useful life
Other Cash Expenses
$60,000.00
Per annum (Years 1-4)
Other Cash Expenses
$76,000.00
Per annum (Years 5-8)
Production Costs
$0.15
Per Unit
Sales price
$0.75
Per Unit (Years 1-4)
Sales price
$1.02
Per Unit (Years 5-8)
Prior sales estimates
Year
Sales
2010
520000
2011
530000
2012
540000
2013
560000
2014
565000
2015
590000
2016
600000
2017
610000
2018
615559
2019
659000
2020
680000
4
d) Calculate the Net Present Value, Internal Rate of Return and Payback Period
The financial controller is considering the use of the Capital Asset Pricing Model as a surrogate discount factor. The risk-free rate is 5 per cent.
Year
Stock Market
Share
Index
Price
2010
2000
$15.00
2011
2400
$25.00
2012
2900
$33.00
2013
3500
$40.00
2014
4200
$45.00
2015
5000
$55.00
2016
5900
$62.00
2017
6000
$68.00
2018
6100
$74.00
2019
6200
$80.00
2020
6300
$83.33
e) Calculate the CAPM
f) Explain why this figure may differ from that calculated above (i.e. Cost of equity – Ordinary Shares)
5
Question 3
Previous Years
Sales
1400
Retained Earnings
170
Costs
900
Dividends
180
Tax rate
0.3
Assets
Liabilities/Equity
Current Assets
Current Liabilities
Cash
460
Creditors
600
Debtors
540
Short Term Notes
100
Inventory
600
Non-Current Assets
Non-Current Liabilities
PP&E
2000
Debentures
900
Total Assets
3600
Owner’s Equity
Retained Profits
1000
Ordinary Shares
1000
3600
Percentage of Sales Approach – Assume all spontaneous variables move as a percentage of sales.
a) Given an expected increase in sales of 12%, what is the amount of external funding required?
b) To maintain the current debt/equity ratio how much debt and how much equity is required?
c) Assuming the company is only operating at 95% capacity, how much new funding (if any) is required?

Answer 1

(a) Calculation of cost associated with each new source of finance:

Bonds:

Given, Face value =$1,000, Discount on issue of bonds =$25, Floatation costs = $10, Coupon rate = 13%

Cost on issue of bonds:

Particulars	Amount
Discount	$25
Floatation costs	$10
Interest on bonds($1000×13%)×67%	$87.10
TOTAL	$122.10

11% Preference Shares:

Given, Face value = $100, Floatation costs = $3

Cost on issue of preference shares:

Particulars	Amount
Floatation costs	$3
Fixed Dividend($100×11%)	$11
TOTAL	$14

Ordinary Shares:

Given, Face value =$100, Discount = $4, Floatation costs = $5.40, Proposed Dividend = $5

Cost on issue of Ordinary Shares:

Particulars	Amount
Discount	$4
Floatation costs	$5.40
Proposed Dividend	$5
TOTAL	$14.40

Therefore cost associated with new source of finance from all three sources = $150.5 per unit.

(b) Calculation of WACC using existing weights:

weight of debt = $10,00,000÷$38,00,000 = 26.32%

Weight of Preference Shares = $8,00,000÷38,00,000 = 21%

Weight of Ordinary Shares = $20,00,000÷38,00,000 = 52.63%

Cost of debt = 122.10÷1,000 = 12.21%

Cost of preference shares = 14÷100 = 14%

Cost of Ordinary Shares (Ke) = (D.P.S ÷ M.P.S) + g

Ke = (4.63÷83.33) + 0.08

Ke = 6%

WACC = 12.21×26.32% + 14×21% + 6×52.63%

WACC = 9.31%

(c) Calculation of WACC using new weights given and it's impact on WACC Calculated in (b)

Weight given, Long term debt = 40%, Preference Shares = 15%, Ordinary Shares = 45%

WACC = 12.21×40% + 14×15% + 6×45%

WACC = 9.68%

Impact: By using new weights, WACC has been increased to 9.68%, and Fixed expenses to be paid has been increased as the weights given to long term debt and preference shares has been increased by 7.68%.