Question

Osama Co. is a listed company operating in the textile industry. Osama Co’s board of directors met recently to discuss a new strategy for the business. The proposal put forward was to sell all the old plant and machinery and use this fund as well as borrow from market to purchase new plant and equipment. The new plant and machinery are more productive and meet the current standard quality required by the international buyers. It is also argued that new plant is more energy efficient and environment friendly that gives more advantage when facing international competitors.

The proposal stated that the funds raised from the sale of the old plant and machinery would be used to buy the new plant and machinery.

New borrowing for the balance amount will be made from local bank which offered lowest rate. Since inflation is on higher side compared to last few years so cost of borrowing is on higher side which will increase firm cost of capital.

The board of directors are of the opinion that increasing the level of debt in OSAMA Co. will increase the company’s risk and therefore it can increase its cost of equity capital. It is assumed that due to change in plant and equipment current local sales of the product will not be affected.

New Plant price                                  Rs.5.32 million

Sales of old plant                                Rs.1.32 million

Firm existing capital structure i.e. debt to assets ratio is 40:60.

At this level firm interest rate on all debt is 9.5%.

After borrowing firm capital structure will shift to 60:40 and at this level firm beta will shift from earlier 1.2 to 1.4. Risk free rate of return is 7% and market risk premium is 6%. New loan is negotiated with HBL bank and it is agreed that this loan will be for five years at 11% mark up.

Instructions:

1. How much borrowing required by firm?
2. Why risk factor will increase if firm is changing its capital structure?
3. What is the current weighted average cost of capital?
4. What the new cost of equity capital?
5. What would be new Weighted Average Cost of Capital?

Answer 1

1)

New borrowing required by the firm = New plant price - Sale of old plant

=5.32 - 1.32 = 4 million

2)

If the company is changing it's capital structure ,that is increasing amount of debt it might not be able to generate similar returns for equity holders with the same level of profitability.

3)

Wieghted average cost of capital = (cost of equity * weight of equity in capital structure) + ( post tax cost of debt * weight of debt in capital structure)

cost of equity = risk free rate + beta * ( market premium)

cost of equity = 0.07 + 1.2 *( 0.06) = 14.2 %

Weighted average cost of capital = ( 14.2 * 0.6) + ( 9.5 * 0.4) = 12.32 %

4 )

new cost of capital ( with new beta )

= 0.07 + 1.4 * (0.06 ) = 15.4 %

5 )

old debt = (assets * 40 ) / 60 = (1.32 * 40) / 60 = 0.88 million ( based on old debt asset ratio )

new debt = 4 million

total debt after taking loan = 0.88 + 4 = 4.88 million

total capital = 4.88 /0.6 = 8.133 million (debt being 60 % in new capital structure)

New weights are as follows-

• Equity = 0.4
• old debt = 0.88 / 8.133 = 0.1
• new debt = 4 / 8,133 = 0.5

New weighted average cost of capital = ( 15.4 * 0.4 )+ ( 9.5* 0.1 ) + ( 11 * 0.5 ) = 12.61 %

Assumptions-

• Due to lack of information on tax rate interest rate given is considerd as post tax .
• Value of old plant and machinnery is being considered as basis of old debt to assets ratio .