Question

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Question 4 Guanteng plc has the following capital structure on their most recent balance sheet: Ordinary shares of $1 5% Preference Shares of $1 5% Convertible Debentures Corporate reserves 450,000,000 150,000,000 25,000,000 80,000,000 The current market value is $1.60 for the ordinary shares. £0.50 for the preference shares and $110 for a loan stock of nominal value of $100. The debentures are redeemable in three years' time at par value or can be converted into 50 shares at that point. It is believed that the share price will grow at 3% during this time period. Note that the preference dividend has just been paid, while an ordinary share dividend of $0.20 per share and the debenture interest are just about to be paid. The company's marginal rate of taxation is 20% and the dividend growth model estimates annual growth at 2% REQUIRED a) Explain what is meant by the term cost of capital' (3 marks) b) Calculate the weighted average cost of capital (12 marks) c) The weighted average cost of capital is deemed inappropriate to use in investment appraisal when both business risk and gearing are changed. Discuss why this is so and how a firm would undertake an appraisal in such circumstances. (10 marks) (Total: 25 marks)

Answer 1

This question pertains to Weighted Average Cost of Capital.Kindly have a look at the answer below:
Solution:- (as cost of capital means arranging capital from different sources of finance. It can be Equity Capital, Preference Capital internal reserves of the company of debentures. It is the return expected by providers of capital (Shareholder y debentweeholder, preference shares holders) from the Company. (b) Calculation of weighted Average cost of Capital (WACC): Cast of Equity: - ke Po = Do (tg) where - Ke-g Po= current share price 9 = growth Do = (wcent year dividend 1.6=0.20(1+0.02) ke- 0.02 16(ke-9.02)-6-20140:204 ke-0.02 = 0.204 Ke = 0.1475 . 14.757 Cost of preference Sharus (kd) Kd = Pie Perence dividend Current price = 1x5% (Dividend calculated on Face Value which is 15 0-5 z 107. Note: - Only Current market value of preference share is given in Lt (pounds) & no other data is given in 't. No conversion sale has been given, so it is taken in & only. Cont. to Page 2

Continued from Page 1 Since Question is silent as to whether it is a company's option to convent or reedeem debenture at par value, it is takenyassumed that it is at debentwee holder's option and hence we ignore convee- Sion into soshares." option Cost of debentures: kid) Note, Nothing said about par value I redemption value of clebentwas so taksit 100$ Kd = Coupon satell- tax) + Redemption -Curwantprice. Value no of years Redemption + Current price • Value = 100x5% (1-0.20) + 100-110 Notea leo+100 • 4 Too 247 Notes' Coupon always calculated on face value Calculation of WACC Notea Ihleights Particulais. Book Value Cost of Capital 100 (2) (3 14-75 10 (3) *(4) 9.41 2:12 4. 0.142 I. 674 Dodinay shares 450000 000 63.827, 54 Reference shares 150 000 000 21- 28. 54-Convertible debenture is ooo ooo 3.55%. e Rescuve soooo ooo 705 000 000 Notes: Weight Calculation Shares = 450 x 10 ! .: WACC = 13.34%. 14.75 (same as Cost of 13:34 Equity Ordinaey shares = 40 Continued to Page 3

Continued from Page 2 : (C) WACC is deemed inappropriate in investment appraisal because it assumes debt and equity in a particular baca bustion. But we are all aware that debt and equity change evera period of time. When they change WACC also changes. An alternative to this is considee taking Weights. as proportion of funds firm tends to employ over time instead of taking book value weights.