Question

Cloudstreet Ltd is an Australian firm which is publicly-listed on the ASX. The company has a long term target capital structure of 60% Ordinary Equity, 10% Preference Shares, and 30% Debt. All of the shareholders of Cloudstreet are Australian residents for tax purposes. To fund a major expansion Cloudstreet Ltd needs to raise a $120 million in capital from debt and equity markets.

Cloudstreet Ltd’s broker advises that they can sell new corporate bonds to investors for $1030 with a coupon of 6% and a face value of $1,000. Issue costs on this new debt is expected to be 1.5% of face value. The bonds will mature in six (6) years. The firm can also issue new $100 preference shares which will pay a dividend of $8 and have issue costs of 5%. The company also plans to issue new Ordinary Shares at an issue cost of 3%. The ordinary shares of Cloudstreet are currently trading at $7.50 per share and will pay a dividend of $0.40 this year. Ordinary dividends in Cloudstreet are predicted to grow at a constant rate of 4% pa.

a.         (i)         Calculate how much debt Cloudstreet will need to issue to maintain their target capital structure.

            (ii).       What will be the appropriate cost of debt for Cloudstreet?

b.         (i)         Calculate how much Preference Share equity Cloudstreet will need to issue to maintain their target capital structure.

            (ii).       What will be the appropriate cost of Preference shares for Cloudstreet?   

c.         (i)         Calculate how much Ordinary Share equity Cloudstreet will need to issue to maintain their target capital structure.

            (ii).       What will be the appropriate cost of Ordinary Equity shares for Cloudstreet?

d.         Calculate the Weighted Average Cost of Capital for Cloudstreet following the new capital raising.   

e.         Cloudstreet Ltd has a current EBIT of $1.5 million per annum. The CFO approaches the Board and advises them that they have devised a strategy which will lower the company’s cost of capital by a full 1%. How will this change the value of the company? Support your answer using theory and calculations.   

Answer 1

(a) (i) Target Capital Structure: 60% Ordinary Equity, 10% Preference Shares, 30% Debt

Target Capital = $ 120 million

Required Debt Level = 120 x 0.3 = $ 36 million

(ii) Bond Market Price = $ 1030, Coupon = 6 %, Face Value = $ 1000, Issue Cost = 15 % of Fce Value = 0.15 x 1000 = $ 150

Total Value to be Recovered through issue = 1030 + 150 = $ 1180

Bond Tenure = 6 years and Annual Coupons = 0.06 x 1000 = $ 60

Let the cost of debt be Y

Therefore, 1180 = 60 x (1/Y) x [1-{1/(1+Y)^(6)}] + 1000 / (1+Y)^(6)

Using EXCEL's goal seek function/ a financial calculator/ hit and trial method to solve the above equation, we get:

Y = 0.027092 or 2.7092 % ~ 2.71 %

(b) (i)

Target Capital Structure: 60% Ordinary Equity, 10% Preference Shares, 30% Debt

Target Capital = $ 120 million

Required Preference Shares = 120 x 0.1 = $ 12 million

(ii) Issue Price = $ 100, Annual Dividend = $ 8 and Issue Cost = 5 %

Therefore, Cost of Preference Shares = 8 / [100 x (1.05)] = 0.07619 or 7.62 %

(c) (i)

Target Capital Structure: 60% Ordinary Equity, 10% Preference Shares, 30% Debt

Target Capital = $ 120 million

Required Ordinary Equity  Level = 120 x 0.6 = $ 72 million

(ii) Current Price = P0 = $ 7.5, Current Dividend = D0 = $ 0.4, Dividend Growth Rate = 4%

Expected Dividend = 0.4 x 1.04 = $ 0.416

Issue Cost = 3 %

Cost of Ordinary Equity = D1 / [P0 x (1-Issue Cost)] + Growth Rate = 0.416 / [7.5 x (1-0.03)] + 0.04 = 0.09718 or 9.72 %

(d) Australian Tax Rate = 30 %

Weighted Average Cost of Capital (WACC) = 0.6 x 9.72 + 0.1 x 7.62 + 0.3 x 2.71 x (1-0.3) = 7.1631 % 7.16 %

NOTE: Please raise a separate query for the solution to the last sub-part as one query is restricted to the solution of only one question with up to four sub-parts.