Question

Royta Ltd, operates in the commercial painting industry. They have reluctantly come to the conclusion that some of their older equipment is reaching the end of its productive life and will need to be replaced sooner or later. They have asked for your assistance in determining their cost of capital in order to make this decision.

Their present capital structure is as follows:

• 1 200 000 R2 ordinary shares now trading at R2,20 per share.
• 80 000 preference shares trading at R1.80 per share (issued at R2 per share). Interest at 10% p.a.
• A bank loan of R 1 000 000 at 10.5% p.a. (payable in 3 years time)

Additional data

1. The company’s beta is 1.4. A return on market of 12% is accepted and a risk free rate of 7% is applicable.
2. The current tax rate is 30%
3. The company’s current dividend is 43c per share and they expect their dividends to grow by 7% p.a.

Required:

1. 1. Assuming that the company uses the CAPM to calculate its cost of equity. Calculate its weighted average cost of capital.                                                                                             
2. 1. A further R800 000 is needed to finance the expansion. Which option should they use (from ordinary shares, preference shares or loan financing)? Provide a reason for your answer.

Answer 1

Solution 1) a) According to the Capital Asset Pricing Model (CAPM), the cost of equity is calculated as:

Re = Rf + Beta*(Rm - Rf)

Re = Cost of equity

Rm = Market return = 12%

Rf = Risk-free rate = 7%

Beta = 1.4

Re = 7% + 1.4*(12% - 7%)

= 7% + 1.4*5%

= 7% + 7%

Re = 14%

Solution 1) b) Weighted average cost of capital (WACC) is calculated as follows:

WACC = wd*Rd*(1 - tax%) + wpe*Rpe + we*Re

Wd, We, Wpe are weights of debt, equity and preferred equity respectively.

Rd, Re, Rpe are the cost of debt, equity and preferred equity respectively.

Rd = 10.5%

Re = 14%

For preferred share, preferred dividend = 10%*2 = 0.2

Current Price of preferred share = 1.8

Rpe = Preferred dividend/Current price = 0.2/1.8 = 11.11%

Value of equity = 1,200,000*2.2 = 2,640,000

Value of preferred equity = 80,000*1.8 = 144,000

Value of debt = 1,000,000

Total capital = 2,640,000 + 144,000 + 1,000,000 = 3,784,000

Wd = 1,000,000/3,784,000 = 0.2642706131

We = 2,640,000/3,784,000 = 0.6976744186

Wpe = 144,000/3,784,000 = 0.03805496828

WACC = 0.2642706131*10.5%*(1 - 30%) + 0.6976744186*14% + 0.03805496828*11.11%

= 1.9424% + 9.7674% + 0.4228%

= 12.1327%

= 12.13%

Solution 2) To finance the further expansion, company should use debt as the source of financing as the after-tax cost of debt is lowest.

After-tax cost of debt = 10.5%*(1-30%) = 7.35%

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