Forums › Ask ACCA Tutor Forums › Ask the Tutor ACCA AFM Exams › Fleet Plc Question – calculating cost of equity the market value
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John Moffat.
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- November 5, 2013 at 2:02 pm #144618
Sir I have slightest of doubt in following question.
QUESTION: The finance team of Fleet plc is undertaking a financial review of a potential
new project. The new project is in the same industry as Fleet plc and the capital
structure of the enlarged company will remain unchanged. The following details
are available:
The capital structure of Fleet plc as at 1st January 20X8 is as follows:
£m
Issued ordinary shares (25p shares) 250
Bank term loan 300
8% irredeemable debenture 600
The ordinary shares have a current market price of £2 each. Dividends per
share in the five preceding years were as follows:
20X3 6.9 pence
20X4 7.2 pence
20X5 8.8 pence
20X6 9.6 pence
20X7 10.5 pence
The dividend for 20X7 has just been paid.
The bank is currently charging 10% on the term loan.
The debenture stock has a market price of £75.
The company pays corporation tax at a rate of 30%.
Required:
Calculate a suitable discount rate for the new project.
ANSWER:(1) Ke ? DVM with growth
Ke = Do*(1+g)/Po + g
Ke =10.50 (1.11 )/200+ 0.11 = 16.83%
Calculation of growth in dividends:
10.5/6.9^0.25 – 1 = 11%(2) Kd(1 – t) /irredeemable debt
Kd(1 – t) = 8 × (1 – 0.3)/75 = 7.47%
(3) Kd(1 – t) – bank term loan
10% (1 – 0.3) = 7%
Doubt:
Sir while calculating cost of equity the market value comes to $2000m rather than $200m and so the cost of equity to be 11.65% as a result . Isn’t this a mistake in the answer.
Moreover sir while calculating irredeemable debenture why its cost had been grossed up by dividing it by 75%.I got 5.6% simply by accounting for tax relief of 30% on 8%.ThankyouNovember 6, 2013 at 4:51 pm #144782With regard to the equity, the shares have a nominal value of 0.25 and the total on the balance sheet is $250M. This means that there are 1,000 M in issue and at $2 per share market value, this is $2,000 M
With regard to the debentures, they have no grossed it up. The have taken the after-tax interest (5.6) and divided by the market value (75). This is correct.
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