Question

The following information relates to MNO Ltd.

• MNO has 300,000 bonds outstanding with a Face Value of $100 each, 10 years to maturity and pay an annual coupon of 5%. The yield on the bonds is 5% p.a. MNO’s marginal corporate tax rate is 30%.
• MNO has 2 million ordinary shares on issue. The shares have a Beta of 1.3, the market risk premium is 10% and the risk-free rate is 5%. These shares are expected to pay a dividend of $5.50, and this dividend is expected to grow at a constant rate of 3% in perpetuity.

(a) What is the MNO’s after-tax cost of debt?

(b) What is MNO’s cost of ordinary shares?

(c) What are the price and market value of MNO’s ordinary shares?

Answer 1

a) Since,Given Yield = Coupon rate = 5%

Price of the bond will be equal to its face value= 100

Therefore after tax cost of debt is given by= 5%*(1-tax rate)

=5%(1-30%)

=3.5%

b) cost of ordinary shares is given by= Rf+ (Rm-Rf)*beta

where Rf is the risk free rate

Rm is the market rate of return

Rm-Rf= Market risk premium

Given Rf= 5%

Rm-Rf= 10%

Beta =1.3

Hence Cost of ordinary = 5%+10%*1.3= 18%

c) For a company paying constant dividend every year Price of the shares is given by= Dividend expected to pay in next year/(cost of ordinary shares - Growth rate)

= 5.5/(18%-3%)

=36.67

There Market value of shares = 2million shares *36.67= 73.33 Million

(Note if it is assumed that 5.5 is the Next year dividend. If it is assumed that 5.5 is the current year dividend then Solution will be = 5.5(1+3%)/(18%-3%)= 37.77)