Question

Official Ltd is an investment company that is considering expanding their business, and as such, is reviewing their current financing mix and the costs of their sources of finance.

The latest balance sheet for the company shows:

Long-term debt $

Bonds: Par $1,000, annual coupon 6% p.a., 4 years to maturity 10,000,000

Equity

Preference shares (100,000 shares outstanding, $3.24 cents per share dividend) 2,000,000

Ordinary shares (1,000,000 shares issued) 8,000,000

Total 20,000,000

The company’s bank has advised that the interest rate on any new debt finance provided for the projects would be 9.45% p.a.

The company’s preference shares currently sell for $22.45, while existing ordinary shares sell for $7.20 each and management has disclosed that it expects to pay a dividend of 45 cents per share at the end of the next year.

Additional information provided by the company include their beta of 0.75, the risk free rate of 3% per annum, the market rate on a diversified portfolio of 10% per annum, while the company’s tax rate is 30%.

(a) Using current market and expected (calculated) values, determine the market value proportions of debt, preference shares and ordinary equity comprising Official Ltd’s capital structure.

(b) Calculate the after-tax costs of capital for each source of finance.

(c) Determine the after-tax weighted average cost of capital for the company.

(d) Under what conditions can the firm’s weighted average cost of capital be used for assessing new projects?

Answer 1