Question

You are given the following information about a company:

1. There are 5,000,000 ordinary shares with a nominal value of 10 pence each and a market value of £12 each.

2. Dividends on ordinary shares are paid annually and a dividend of 80 pence has just been paid.

3. Dividends on ordinary shares have been increased by around 5% p.a. and there is no reason to believe this will change in the future.

 There is a bank loan of £20,000,000 on which an interest payment of 7.5% is paid once per year.

 There are 2,000,000 preference shares with a nominal value of £5 each and a market value of £6 each.

4. The preference shares each pay an annual dividend of 50 pence and a dividend has just been paid.

5. The company has issued 10,000 bonds with a face value of £1000 each and which have a current market value of £1000 each.

6. The bonds have annual coupons of £125 and have just paid a coupon.

7. The bonds have 10 years left to maturity.

(a) If the corporate tax rate is 20%, estimate:

(i) the cost of ordinary shares.

(ii) the cost of the bank loan.

(iii) the cost of preference shares.

(iv) the cost of the bonds.

(v) the weighted average cost of capital (WACC).

Show how you get the above answers with proper steps, please. Thank you

Answer 1

Answer :

(i) Cost of ordinary shares = ( Expected dividend / Market Price ) + growth rate

                                              = ( 0.80 / 12 ) + 0.05

                                             = 0.0667 + 0.05

                                             = 0.11667 or 11.667%

(ii) Cost of bank loan = Interest rate * (1 – tax rate)

                                     = 7.5% * ( 1 – 0.20)

                                     = 6%

(iii) Cost of preference shares = ( Dividend / Nominal Price )

                                                      = (0.50 / 5 )

                                                     = 0.10 or 10%

(iv) Cost of bond = 10%

After tax = 12.5% * ( 1 – tax rate)

                 = 12.5 * ( 1- 0.20)

                 = 10 %

For bond whose market value is equal to its face value, then its cost will be its dividend yield only.

Dividend yield = 125 / 1000

                           = 0.125 or 12.5%

WACC = (Weight of ordinary Share * Cost of ordinary share) + (Weight of loan * Cost of loan) + (Weight of preference Share * Cost of preference share) + (Weight of bond * Cost of bond)

Where,

Total Capital = Market Value of ordinary share + Loan Value + Market Value of preference capital + Market value of bond

                       = (12 * 5,000,000) + (20,000,000) + (2,000,000* 6) + (10,000* 1000)

                    = 60,000,000 + 20,000,000 + 12,000,000 + 10,000,000

                    = 102,000,000

Weight of ordinary Share = 60,000,000 / 102,000,000 è 30/51

Weight of loan = 20,000,000 / 102,000,000 è 10/51

Weight of preference Share = 12,000,000 / 102,000,000 è 6/51

Weight of bond = 10,000,000 / 102,000,000 è 5/51

(v) WACC = (30/51 * 11.667%) + (10/51 * 6%) + (6/51 * 10%) + (5/51 * 10%)

   WACC = 6.86% + 1.18 + 1.17 + 0.98

     WACC = 10.19%