Question 2 MM Co capital structure is as follows; Km Equity shares 12·5 Retained

Question

Question 2

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

Soln : a) i) Loan captal to the company = K 10million, coupon = 8%, redeemable in years

Let r be the cost of capital. Using the NPV method we can say the price of the bond,

P = 8/(1+r) + 8/(1+r)2 + 108/(1+r)3, , 95 = 8/(1+r) + 8/(1+r)2 + 108/(1+r)3,

On solving we get r = 10%, using hit & trial method

cost of loan capital = 10%

ii) Cost of equity capital , let be R . Now dividend paying every year = profits (100% payout)

Please refer here the cash flows as dividend:

We can see that dividend growth rate = profit growth rate = 8% (approx.)

So, in case p is the price, we can say p = 0.1588/(R-8%) or 6.08 = 3.97/(R-0.08)

R = 2.61 +8 = 10.61%

cost of equit capital = 10.61%

iii) Now, need to calculate the weighted avg. cost of capital, W = Debt/(debt + equity) *r *(1-tax rate ) + equity/(debt + equity) *R = 10/22.5 *10% *(1-0.35) + 12.5/22.5 * 10.61% = 8.78%

b) Cost of capital helps in capital budgeting, as for any project rate of return should be higher than cost of capital, else it is loss making thing. Hence, calculating the cost of capital is very important and need to be taken care .

Year 2015 2016 2017 1018 Dividend 3.97 4.29 4.63 5 share 25 25 25 25 Dividend per share 0.1588 0.1716 0.1852 0.2

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