The finance director of Kadlex plc is currently reviewing the capital structure

Question

The finance director of Kadlex plc is currently reviewing the capital structure of her company She is convinced that the company is not financing itself in a way that minimises its cost of capital (WACC). The company's financing as at 31 December 2017 is as follows: £000 Ordinary shares, £1 each 20000 Reserves 5000 796 preference shares, £1 each 10000 10% bonds (irredeemable 31 December 2017) 15000 Total capital 50000 Other information from stock market (as at 31December 2017): Ordinary share price (ex-div) Preference share price (ex-div) Bond price for 10% bonds Last 5 years' dividends (most recent last) £2.65 15P E107 per £100 21p, 23p, 25p 27p, 28p The finance director feels that by issuing more debt the company will be able to reduce its cost of capital. She proposes the issue of £15m of 11 per cent bonds. These bonds will be sold at a 5 per cent premium to their par value and will mature after seven years. The funds raised will be used to repurchase ordinary shares which the company will then cancel. She expects the repurchase will cause the company's share price to rise to £2.85 and the future dividend growth rate to increase by 20 per cent (in relative terms). She expects the price of the 10 per cent bonds to be unaffected, but the price of the preference shares to fall to 68p. Corporate tax stands at 30 per cent. Calculate the book value and market value cost of capital (WACC) for Kadlex plc

Explanation / Answer

(All figures in ‘000)

Capital structure after issue of bonds:

Proceeds from bonds = 15750 +5% = 15750

Number of shares bought back = 15750/2.65 = 5943 approximately 5940

The company will have:

Ordinary shares = 20000-5940 = 14060

7% Preference shares = 10000

10% bonds = 15000

11% bonds = 15000

Weights of the capital sources are: 26%, 18%, 28%, 28% (Each component / Total capital)

Cost of equity = (D(1+g) / P)+g where (D – average dividend, g – growth rate, P – price)

Average dividend = (.21+.23+.25+.27+.28)/5 = .24

Cost of equity = (0.24(1+20%)/2.85)+20% = 12.5%

WACC as per book values = Weight of debt (Cost of debt)(1-tax rate) + weight of equity (cost of equity) + weight of preferred stock (Cost of preferred stock)

WACC = (0.1)(0.28)(1-0.3) + (0.11)(0.28)(1-0.3) + (0.07)(0.18) + (0.125)(0.26) = 0.085 = 8.5%

Market values of these components:

Equity – 5940*2.65 = 37259

Preferred stock – 10000*.75 = 7500

10% bonds – 1500*107 = 16050

15% bonds – 15000

Weights of each: 49%, 10%, 21%, 20%

WACC as per market value= (0.49)(0.125) + (0.98)(0.07) + (0.21)(0.1)(1-0.3) + (0.19)(0.11)(1-0.3) = 10%

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