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Questions:
The management of Custer plc are trying to decide on a cost of capital to apply to the evaluation of investment projects.
The company has an issued capital of 500,000 ordinary shares, with a current share price of 117c. it has also issued $200,000 of 10% debenture, redeemable in 2 years’ time with current price of 105.30
The ordinary dividend and debenture interest are due to be paid in the near future. The ordinary dividend will be $60,000 this year, and will be 5% more each year for the foreseeable future. What is the cost of capital for Custer plc? Assumed tax rate at 30%Solution:
Po= ex dividend price =117 – 60,000/500,000*100 = 105 cent.
ke = d1/Po + g = 17%Ex interest price = market price of debenture = 105.30 – 100*10% = 95.30 and kd is calculated as follows:
What I concerns here is why current price is not current market price of the share price and debenture. Does current price always mean cum dividend/cum interest price?
In the questions, they do not mention the par value of debenture but the solution assume the interest would be = 10%*100. Does it mean par value always be 100 in the question and debenture always redeemed at par value?
Thank you for your kind answer
The question says that the dividend and interest are about to be paid – this means that the market values will be cum div / cum int.
If the question had not said anything about when the dividend/interest were to be paid, then we always assume that they want an ex div / ex int price.
Bonds, debentures etc. in the exam always have a nominal/par value of $100 unless the question says different. Redemption is always at nominal value, unless the question says they are redeemed at a premium.
All of this is explained in my free lectures. The lectures are a complete free course for Paper F9 and cover everything needed to be able to pass the exam well.
Thank John for your kind answer.
I have additonal questions and could appreciate your additional explanation. Per your above explaination, I understand that the market value of debenture and share price could be cum div/cum int. However, the solution says that the market value is ex div/ex interest? So it is not correct?
When calculating the WACC we always use the ex-div market values.
Since the MV’s are given cum div and cum int, we need to subtract the dividends to get the ex div MV’sAgain – this is all explained in the lectures. Are you watching the lectures?
Dear John,
Thank you for your kind answer again. Sorry for late reply. I totally understand your point and am aware that when calculating WACC, we always use the ex-div market values. Just your point ” the market values will be cum div / cum int” makes me confused.
Thank you very much for your kind answer
The question says that the dividend and interest are to be paid in the near future. This means that the market values given are cum div / cum int, and to get the ex div / ex int market values we subtract the dividend or interest about to be paid, as I explain in my free lectures.
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