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PRQ plc has the following long-term debt and equity investment:
5% debentures at a par value of £5,500,000. Each debenture has a face value of £100 and is trading at 90 ex int. The debentures will be redeemed at a premium of £5 in four years.
9% debentures at a par value of £7,000,000. Each debenture has a face value of £100, and is trading at £71 ex int. These debentures are irredeemable.
A secured bank loan of £4,000,000. The current rate of finance of this type of loan and risk class is 6.5%.
2,000,000 £1 8% irredeemable preference shares, which are trading at 88p cum div. When calculating the cost of capital ex div (or ex int.) prices must be used.
30,000,000 50p ordinary shares. The most recent dividends are about to be paid and are included in the creditors due within one year. It is expected that the dividends will grow by 10% per annum. The current EPS is 10p and the price to earnings ratio is 11.
Tax is payable at 33% and the total dividends in creditors is £1,360,000.
Required
Explain what is meant by cost of capital of a company.
Based on the above figures, calculate the cost of capital of PRQ plc.SUGGESTED SOLUTION
Value(equity) = 30m x (10 x11) = £33m
Value(5% debenture) = 5.5m x 90/100 = £4.95m
Value(9% debenture) = 7m x 71/100 = £4.97m
Value(preference shares)= 2m x 0.8 = £1.6m
Value(bank loan) = £4mTotal value = £48.52m
Ke = (D1 / P) + g
Dividend = 1,360,000 – (8% x 2,000,000) = £1,200,000
Per share = 1,200,000 / 30,000,000 = 4p/share
Ke = (4 x 1.1 / 110) + 0.1 = 0.14 or 14%
Kp = 8 / 80 = 10%Kd (Bank) = 6.5% x (1-t) = 6.5% x 0.67 = 4.4% (approx.)
Kd (9% debenture) = 9 x 0.67 / 71 = 8.5%
Kd (5% debenture)
Interest net of tax = 5 x 0.67 = £3.35
90 = 3.35 x (1+r)-1 + 3.35 x (1+r)-2 + 3.35 x (1+r)-3 + 108.35 x (1+r)-4Try r = 7%, gives price as £91.45
Try r = 8%, gives price as £88.27Therefore r is approx. 7.46%, to give price of £90
Hence Kd (5% debenture) = 7.46%
WACC = (14% x 33 + 7.46% x 4.95 + 8.5% x 4.97 + 10% x 1.6 + 4.4% x 4) / 48.52
WACC = 11.8%
Value(equity) = 30m x (10 x11) = £33m i’m not sure about this.
Kp = 8 / 80 = 10% i’m not sure about this. Why is /80? I think it is 88p
And i not sure all the Kd of 5% debenture..
Kd (5% debenture)Interest net of tax = 5 x 0.67 = £3.35
90 = 3.35 x (1+r)-1 + 3.35 x (1+r)-2 + 3.35 x (1+r)-3 + 108.35 x (1+r)-4Try r = 7%, gives price as £91.45
Try r = 8%, gives price as £88.27Therefore r is approx. 7.46%, to give price of £90
Hence Kd (5% debenture) = 7.46%
I don’t know where you got the question from – it is not a very good one!! (and is all in GBP whereas the exam is all in $’s 🙂 )
The price earning ratio is market value/earnings per share. So, for this question, the market value is 11 x 10p = 110p. So 30m shares have a market value of GBP 33m.
The market value of the preference shares is 88p, but this is a cum div value (because the dividend is about to be paid) and it is the ex div value that is needed to calculate the cost. Since the dividend is 8% of nominal – 8p – the ex div value is 88 – 8 = 80p.
(Actually the answer should have done the same for the ordinary shares but has not!).
For cost of debt, the answer shows the workings in a slightly strange way, but effectively you are calculating the Internal Rate of Return of the after tax flows.
If you are not clear about this then watch my lecture on it on this website.
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