Question

QUESTION FOUR [20] Sheffield Manufacturers Ltd, operate in the printing and packaging industry. They feel that some of their older printing and labelling machines need to be replaced. They seek your help in order to calculate their cost of capital.

Their present capital structure is as follows:  800 000 R2 ordinary shares now trading at R2,50 per share.

 250 000 preference shares trading at R2 per share (issued at R3 per share). 10% fixed rate of interest.

 A bank loan of R 1 500 000 at 13% p.a. (payable in 5 years’ time).

Additional data

 The company’s beta is 1.3. The return on the market is 14% and the risk free rate is 7%.

 Its current tax rate is 28%.

 Its current dividend is 40c per share and it expects its dividends to grow by 8 % p.a.

Required:

4.1. Assuming that the company uses the Dividend Growth Model to calculate its cost of equity. Calculate its weighted average cost of capital. (17)

4.2. If a further R500 000 is needed to finance the expansion, which option should they use from either ordinary shares, preference shares or loan financing and why? (3)

Answer 1

4.1

cost of Equity = ((dividend*(1+growth rate)) / value of share) + Growth rate

= ((0.40(1+0.08))/ 2.5 + 0.08

= 0.1728+0.08

=0.2528

=25.28%

cost of preference share = Dividend/ value of preffered stock

= 0.3/2

= 0.15

=15%

cost of debt = coupon rate (1- tax rate)

=13(1-0.28)

=9.36%

weighted average cost of capital

=((total debt*cost of debt)+(total p. stock*preffered cost )+(total common stock*cost of c. stock))/ total capital invested

=((1500000*9.36)+(500000*15)+(625000*25.28))/2625000

=14.22%

4.2

according to above calculation the lowest cost of capital is debt so if we want to get 500000 we should use the debt or a bond issue, one of the reason for bonds are cheaper is that they are having the shield against income tax. so we should use the bond