Question

WRE Energy Limited is a major oil and gas exploration company in Western Australia. It currently has $300 million of market value debt outstanding, consisting of 9% coupon bonds with a maturity of 15 years. The bonds pay semi-annual coupons. The face value of each bond is $1,000 and are currently priced at $1,024.87 each. The company also has an issue of 2 million preference shares outstanding with a market price of $20 each, paying an annual dividend of $1.20. WRE Energy also has 14 million ordinary shares outstanding with a price of $25.00 per share. The company is expected to pay a $2.20 ordinary dividend 1 year from today, and that dividend is expected to increase by 7% per year forever. The relevant corporate tax rate is 30%.

a. Outline the necessary steps required to estimate the company’s weighted average cost of capital.

b. Calculate the after-tax cost of each of the company’s current financing sources .

c. Using the information provided, calculate the market values for the financing sources for WRE Energy .

d. Using the information from b.) and c.) calculate the company’s after-tax weighted average cost of capital .

(SHOW WORKINGS PLEASE)

Answer 1

	a	STEPS TO ESTIMATE WEIGHTED AVERAGE COST OF CAPITAL
	STEP1	Bonds:
		Calculated cost of Bond by determining Yield To Maturity(YTM) and taking into account tax shield on interest
		Calculate total Market Value of bond
	STEP2	PREFERENCE SHARES:
		Calculated cost of Preference shares from dividend payments required
		Calculate total Market Value of Preference shares
	STEP3	ORDINARY SHARES
		Calculated cost of ordinary shares by determining required returns
		Calculate total Market Value of Ordinary shares
	STEP4	Calculate total market value of capital
		Calculate weight of Bond, preference shares and ordinary shares in total capital
	STEP5	Calculate Weighted Average Cost of Capital(WACC)
		WACC=Wb*Cb+Wp*Cp+We*Ce
		Wb=Weight of Bond in the total capital
		Wp=Weight of Preference Shares in the totalcapital
		We=Weight of Common Shares in the total capital
		Cb=Cost of bond
		Cp=Cost of Preference shares
		Ce=Cost of Ordinary Shares
	b	AFTER TAX COSTS:
		Bonds:
		Face value of each Bond	$1,000
		Coupon Rate	9%
	Pmt	Semi annual Coupon Payment=1000*9%*(1/2)	$45.00
	Nper	Number of payments	30	(15*2)
	Pv	Current marke Value of each Bond	$1,024.87
	Fv	Amount to paid at maturity	$1,000
	RATE	Semi annual Yield To Maturity(Using RATE function of excel with Nper=30,Pmt=45,v=-1024.87,Fv=1000)(Excel command: RATE(30,45,-1024.87,1000)	4.35%
		Annual effective rate =(1.0435^2)-1=	8.89%
	Cb	After Tax Cost of Bond =8.89*(1-Tax Rate)=8.89*(1-0.3)=	6.22%
		Preference shares
		Annual Dividend=$1.20
		Market Value=$20
	Cp	Cost of Preference Shares=1.2/20=	6.00%
		Ordinary Shares:
		D1=Next Years dividend=$2.2
		g=Dividend Growth Rate=7%=0.07
		P0=Market Price =$25
		R=Required rate of return
		P0=D1/(R-g)=$25
		R-g=D1/25
		Required Return =(2.2/25)+0.07=	15.80%
	Ce	Cost of Ordinary Shares=15.80%
	c	MARKET VALUE
	A	Market value of bond=	$300	million
	B	Market Value of preference Shares=2million*$20	$40	million
	C	Market Value of Ordinary shares=14 million *$25	$350	million
	D	Total Market value of capital	$690	million
	Wb=A/D	Wb=Weight of Bond in the total capital	0.43
	Wp=B/D	Wp=Weight of Preference Shares in the total capital	0.06
	We=C/D	We=Weight of Common Shares in the total capital	0.51
	d	After Tax Weighted average Cost of Capital:
		WACC=Wb*Cb+Wp*Cp+We*Ce=6.22*0.43+6*0.06+15.8*0.51=	11.07%