Question MM Co capital structure is as follows; Km Equity shares 12·5 Retained e
ID: 2815185 • Letter: Q
Question
Question
MM Co capital structure is as follows;
Km Equity shares 12·5 Retained earnings 15·0 Loan capital 10·0 37·5
Over the past four years, the company has generated the following after-tax profits which have all been paid out as dividend based on the current dividend policy of 100 per cent pay-out.
After-tax profits or total dividends for the year ended 30 June
Year 2015 2016 2017 2018 Profits or Dividends (Km) 3·97 4·29 4·63 5·00
The directors of MM Co is currently considering whether to recalculate the company’s cost of capital. When evaluating investment decisions, the board uses the net present value method and uses a cost of capital of 18%. This figure, however, was calculated four years ago and since then the company has undergone various changes. The following information is also available:
The loan capital consists of 8% bonds that are redeemable in three years’ time. The current market value of the bonds is K95 per K100 nominal value. The loan capital will be redeemed at its nominal value in three years’ time.
The company has 25 million equity shares in issue and these shares are currently trading at K6.08 per share. Recently, the directors decided to maintain the current capital structure of the company for the foreseeable future. Assume a tax rate of 35%.
Required:
a) Calculate, for MM Co, each of the following: i. the cost of loan capital; ii. the cost of equity capital; and, iii. the weighted average cost of capital based on both book values and market values.
b) Briefly state why it is important for a company to carefully calculate its cost of capital.
Explanation / Answer
COST OF LOAN CAPITAL: A Current Market Value of Bonds 95,000 B Face value of Bonds 100,000 C Loan Capital 10,000,000,000 D=C/B Number of Bonds 100,000 E=A*D Market Value of Bonds 9,500,000,000 F Number of years to maturity 3 G=0.08*B Annual interest per bond(8%) 8,000 H Yield to Maturity 10.0% (Using RATE fnction of excelwith Nper=3, Pmt=8000, PV=-95000, FV=100000) I Before Tax Cost of Debt 10% J Tax rate 35% K=H*(1-J) After tax cost of Debt 0.065071253 Cd Cost of Loan Capital 6.5% COST OF EQUITY CAPITAL: Year Dividend 2015 3,970,000,000 2016 4,290,000,000 2017 4,630,000,000 2018 5,000,000,000 g Average dividend growth ratein 3 years= 0.079923933 ((5/3.97)^(1/3))-1 M=5.00*(1+g) Expected Dividend next year 5,399,619,663 N Number of shares 25,000,000 numbers D1=M/N Expected dividend per share next year 215.9847865 P0 Current Share Price 6,080 R=(D1/P0)+g Required Rate of Return 0.115447746 R Required Rate of Return(Percentage) 11.5% Ce COST OF EQUITY CAPITAL: 11.5% Weighted Average Cost of Capital(WACC) Based on Book Values: S Book Value of Loan Capital 10 Km T Book Value of Equity capital(12.5+15) 27.5 Km U=S+T Total bookvalue of capital 37.5 Km Wbd=S/U Weight of Loan capital 0.266666667 Wbe=T/U Weight of Equity Capital 0.733333333 WACC=Wbd*Cd+Wbe*Ce Weighted Average Cost of Capital(WACC) 0.102014015 Weighted Average Cost of Capital(WACC) 10.2% Weighted Average Cost of Capital(WACC) Based on Market Values: X Market Value of Loan Capital 9,500,000,000 V=N*P0 Market Value of Equity Shares 152,000,000,000 W Retained Earnings 15,000,000,000 Y=V+W Market Value of Equity capital 167,000,000,000 Z=X+Y Total Market value of capital 176,500,000,000 Wmd=X/Z Weight of Loan capital 0.053824363 Wme=Y/Z Weight of Equity Capital 0.946175637 WACC=Wmd*Cd+Wme*Ce Weighted Average Cost of Capital(WACC) 0.112736264 Weighted Average Cost of Capital(WACC) 11.3% It is important for a company to carefully calculate cost of capital becasuse Cost of Capital is used for taking important decisions of capital budgeting
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