Question

IRM 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:

1.1 Assuming that the company uses the CAPM to calculate its cost of equity. Calculate its weighted average cost of capital.

1.2 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

		Before tax Cost of Bank Loan	10.50%
	Cd	After tax cost of Bank Loan =10.5*(1-tax rate)	7.35%	(10.5*(1-0.3)
		Cost of Preferred Stock:
		Selling price per share:	$1.80
		Annual Dividend payment=10%*2	$0.20
	Cp	Cost of Preferred Stock=0.2/1.8=	11.11%
		Required Return on Common Equity=Ce
		Cost of Equity as per CAPM Equation
		Cost of Equity=Rf+Beta*(Rm-Rf)
		Rf=Risk free rate =7%
		Beta=1.4,
		Rm-Rf=Market Risk Premium=(12-7)=5%
	Ce	Cost of Equity =7+1.4*5=	14.00%
		Market Value of Capital Structure
	Md	Market Value of Bank Loan	1,000,000
	Mp	Market Value of Preference shares	144,000	(1.8*80000)
	Me	Market value of Equity	2,640,000	(1200000*2.2)
	M=Md+Mp+Me	Total Market value of Capital	3,784,000
	Wd=Md/M	Weight of Debt	0.2643
	Wp=Mp/M	Weight of Preferred Stock	0.0381
	We=Me/M	Weight of Equity	0.6977
		Weighted Average Cost of Capital (WACC)=Wd*Cd+We*Ce+Wp*Cp
		Weighted Average Cost of Capital (WACC)=0.2643*7.35+0.0381*11.11+0.6977*14
		WACC=	12.13%
	1.2	For additional finance , loan financing should be chosen
		Cost of loan financing is minimum