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:

a. The company’s beta is 1.4. A return on market of 12% is accepted and a risk free rate of 7% is applicable.

b. The current tax rate is 30%

c. The company’s current dividend is 43c per share and they expect their dividends to grow by 7% p.a.

Required:
4.1 Assuming that the company uses the CAPM to calculate its cost of equity. Calculate its weighted average cost of capital.
4.2 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

a. In the current question we are given the overall beta of the company. Using the base of beta of the company and the CAPM we can calculate the overall cost of capital of the company using the following formulae:

Cost of Capital of the company= Risk free rate + Beta of the company*( Return from the market- Risk free return)

Thus the cost of the capital of the company equals= 7%+1.4( 12%-7%)

=14%

Thus using the cost of the company we can calculate the cost of equity by the following equation:

Cost of the company= Cost of Equity (Ke) * Weight of Equity(We) + Cost of Debt (kd)* Weight of Debt (Wd) + Cost of Preference Share (Kp) * Weight of Preference Share (Wp)

14%=Ke*0.697+7.35%*0.264+10%*0.038

14%=0.697Ke+2.3204%

Ke= 16.756%

Working Notes:

Cost of Debt (Kd)= 10.5% (1-30%)= 10.5%*0.7= 7.35%

Cost of Preference Share (Kp)= 10%

Total Capital Employed= Equity share capital + Prefernce share capital + Debts

We can either use the market value or the book value to calculate the debt. But in case where both is mentioned and the question does not specifies specifically it is preferable to use the market value.

Thus the capital employed is= (1,200,000*2.2)+(80,000*1.8)+1,000,000

= 2,640,000+144,000+1,000,000

=3,784,000

Weight of equity(We)= 2,640,000/3,784,000= 0.697

Weight of Preference Share (Wp)= 144,000/3,784,000= 0.038

Weight of Debt (Wd)= 1,000,000/3,784,000= 0.264

a. Thus the cost of equity is 16.75% and the weighted average cost of capital is equal to the cost of teh company which is 14%.

b. If the company wants to raise an additional capital of R 800,000 the company has a following 3 options:

i. Equity share

ii. Preference Share

iii. Debt

The current Preference share has a Interest rate of 10%. And the current debt has a rate of 10.5%. And if debt is raised it will also earn a tax saving of 30% and thus the cost of borrowing from debt shall be 7.35%. Thus a company shall raise through debt instead of preference share.

In case of comparision of the debt and equity. So as per the CAPM the Cost of equity is more ie 16.75% as compared against 7.35% of debt.

Also if we calcuate the Cost of equity based upon the dividend declared and the current market price it shall be

Cost of Equity= (Dividend Paid* (1+growth rate)/Current market price)+ Grwoth rate

Cost of Equity= ( 0.43*(1+7%)/2.2)+7%

Cost of Equity= (0.4601/2.2)+0.07

Cost of equity= 28%

Since as per the current dividend payout the cost of equity is more as compared to the cost of equity as per the CAPM, and also is greater than than the cost of debt thus the company should focus on raising the funds from the debts.