Question

1. Londoni Kokowe Chombo PLC one of the companies listed on the LSE wishes to calculate its updated weighted Average cost of capital for use in their investment appraisal process ZMK Million 2,000 Issued share capital (K100 shares) 1,300 Share premium 145 Reserves Share Holders funds 3.445 6% irredeemable Debentures 1,400 9% Redeemable debentures 1,450 Bank loan 500 Total Long-term liabilities 3,350 The current cum interest market value per K100 unit is K103 and K105 for the 6% and 9 % debentures respectively. The 9 % debenture is redeemable at par in 10 years' time. The bank loan bears interest rate of 2 % above the base rate (current base rate is 15 %) . The current ex-div market price of shares is K1,100 and a dividend of K100 per share which is expected to grow at a rate of 5 % per year has just been paid. The effective corporation tax rate for Londoni Kokowe Chombo PLC is 30%. Required (a) Calculate the effective after tax Weighted Average Cost of Capital (WACC) for Londoni Kokowe Chombo PLC. (20 Marks) (b) Using the traditional theory of capital structure explain what would happen if the company took on additional debt finance. (10 marks cs Scanned with CamScanner

Answer 1

		Total Market value of 6%debentures=1.03*1400=	1,442.00	million
		Total Market value of 9%debentures=1.05*1450=	1,522.50	million
		Bank Loan	500.00	million
		Market Price of each share of common stock	1,100.00
		Number of shares of common stock outstanding(million)	20.00	(2000/100)
		Total Market value of Common stock=1100*20=	22,000.00	million
	a	Total Market value of 6%debentures	1,442.00	million
	b	Total Market value of 9%debentures	1,522.50	million
	c	Total Market value of Common stock	22,000.00	million
	d	TotalBankLoan	500.00	million
	e=a+b+c+d	Market Value of Total Capital	25,464.50
	Wa=a/d	Weight of 6% debentures in the capital structure	0.06
	Wb	Weight of 9% debentures in the capital structure	0.06
	Wc=b/d	Weight of Common Shares in the capital structure	0.86
	Wd=c/d	Weight of BankLoan in the capital structure	0.02
		AFTER TAX COSTS:
	Ca	6% Debenture after tax cost =6*(1-0.3) (Tax rate =30%)	4.20%
		9% Debentures par value	100.00
	Pmt	Annual interest payment =9%*100	9.00
	Nper	Number of payments	10
	Pv	Current marke Value of each Debenture	105.00
	Fv	Amount to paid at maturity	100.00
	RATE	Annual Yield To Maturity(Using RATE function of excel with Nper=10,Pmt=9,Pv=-105,Fv=100)	8.25%	(Excel Command: RATE(10,9,-105,100)
	Cb	After Tax Cost of 9% debentures =8.25*(1-Tax Rate)=8.25*(1-0.3)=	5.77%
		Common Shares:
		Dividend Growth Rate=5%	0.05
		D1=Next Years Dividend =100*1.05=	105.00
		Current marke Price of Shares=P0=1100
		Required Return=(D1/P0)+g
		Required Return =(105/1100)+0.05=	14.55%
	Cc	Cost of Equity =	14.55%
		Before Tax Cost of Bank Loan=(15+2)=	17.00%
	Cd	After tax cost of Bank Loan =17*(1-0.3)=	11.90%
		After Tax Weighted average Cost of Capital:
		WACC=Wa*CaWb*Cb+Wc*Cc+Wd*Cd=0.06*4.20+0.06*5.77+0.86*14.55+0.02*11.90	13.38%
		AFTER TAX WEIGHTED AVERAGE COST OF CAPITAL	13.38%
	b	If Company takes on additional debt, the risk will increase and Cost of Equity will increase
		Cost of additionaldebt will also increase
		If Company takes on additional debt,Weighted Average Cost of Capital will go up