Question

The following is an extract from the statement of financial position of
Verona Co at 30 September 2004:
R
Ordinary shares of 25 cents each 250,000
Reserves 350,000
7% preference shares of R1 each 250,000
15% long-dated bonds 150,000
–––––––
Total long-term funds 1,000,000
–––––––
The ordinary shares are currently quoted at R1.25 each, the bonds
trading at R85 per R100 nominal and the preference shares at 65 cents
each. The ordinary dividend of 10 cents has just been paid, and the
expected growth rate in the dividend is 10%. Corporation tax is at the
rate of 30%.

Required:
Calculate the weighted average cost of capital for Verona Co.

Answer 1

Calculation of Cost of Long Term Fund/Debt

After tax Cost of Debt = Interest / Issue Price * (1 – Tax Rate)

= 15 / 85 * (1 – 0.30)

= 0.1235 or 12.35%

Cost of Preference Share

Preference Dividend = R1 * 7% = 0.07

Current Issue Price of Preference Share = 0.65

Cost of Preference Share = Dividend 0.07 / Issue Price 0.65

= 0.10769 or 10.77%

Cost of Equity

Next Equity Dividend = 0.10*1.1 = 0.11

Issue Price = R1.25

Cost of Equity = Next Expected Dividend 0.11 / Issue Price 1.25

= 0.088 or 8.80%

Weighted Average Cost of Capital can be calculated either based on book value or based on market value. Since it is not specified in the question, I am calculating for both.

Weighted Average Cost of Capital (based on book value)

	Book Value	Weight	Cost of Capital	Weighted Average Cost of Capital (Weight * Cost of Capital)
Ordinary Share Plus Reserve	600000	0.60 (600,000/1000,000)	0.088	0.0528
Preference	250000	0.25 (250,000/1000,000)	0.1077	0.0269
Long Term Debt	150000	0.15 (150,000/1000,000)	0.1235	0.0185
TOTAL	1000000			0.0983

Weighted Average Cost of Capital (based on book value) = 0.0983 or 9.83%

Weighted Average Cost of Capital (based on Market Value)

	Number of Shares / Bonds	Market Price per bond/share	Market Value	Weight	Cost of Capital	Weighted Average Cost of Capital (Weight * Cost of Capital)
Ordinary Share	1000000 (250,000/0.25)	1.25	1250000 (1000,000*1.25)	0.81169 (1250,000/1540,000)	0.088	0.0714
Preference	250000 (250,000 / 1)	0.65	162500 (250,000*0.65)	0.10552 (162,500/1540,000)	0.1077	0.0114
Long Term Debt	1500 (150,000 / 100)	85.00	127500 (1500*85)	0.08279 (127,500/1540,000)	0.1235	0.0102
TOTAL			1540000			0.0930

Weighted Average Cost of Capital (based on Market Value ) = 0.0930 or 9.30%