Assignment instructions:
The CFO of ABC plc is analysing the capital structure of the organisation. He claims that ABC is not
financing itself in a way which reduces its cost of capital (WACC). The information below represents
the ABC’s financing as at 31 December 2016:
£000
Ordinary shares, £1 each 20000
Reserves 5000
7% preference shares, £1 each 10000
10% bonds (irredeemable 31 December 2016) 15000
Total capital 50000
her information from stock market (as at 31December 2016): Ordinary share price (ex-div) £2.65
Preference share price (ex-div) 75p
Bond price for 10% bonds £107 per £100
Last 5 years’ dividends (most recent last) 21p, 23p, 25p 27p, 28p
The CFO states that by issuing more debt ABC will lower its cost of capital. He suggests issuing
£15m of 11 per cent bonds. These bonds will be sold at a 5% premium to their par value and will
mature after 7 years. The money will be used to repurchase ordinary shares which ABC will further
cancel. The CFO presumes that repurchasing will result in the organisation’s share price rise to
£2.85 and the future dividend growth rate to grow by 20% (relatively). He anticipates the price of the
10% bonds to be unaffected, but the price of the preference shares to drop to 68p. Corporate tax
stands at 30%.
You are required to:
1) Calculate the book value and market value cost of capital (WACC) for ABC plc. (35 marks)
2) Considering the proposed changes to ABC’s capital structure, recalculate the
organisation’s cost of capital to reflect these changes and comment on the CFO’s
forecasts. (35 marks)
3) Critically analyse whether you consider that organisations, by integrating a sensible level
of gearing into their capital structure, can decrease their WACC, ensuring the response integrates
relevant empirical research within this area of study. (30 marks)
Finance Homework
Share
Book value weights:
To find the market value weights, we can use the prices provided in the information:
Market value weights:
Book value cost of capital (WACC): WACC = (0.4 * cost of equity) + (0.1 * cost of reserves) + (0.2 * cost of preference shares) + (0.3 * cost of bonds)
To find the cost of equity, we can use the Gordon Growth Model: Cost of equity = (D1/P0) + g D1 = the next expected dividend (28p) P0 = the current share price (2.65) g = the expected growth rate of dividends (5%)
Cost of equity = (28/2.65) + 0.05 = 11.32%
To find the cost of the 7% preference shares, we can use the current market price: Cost of preference shares = 7%
To find the cost of the 10% bonds, we can use the current market price: Cost of bonds = 10%
Cost of reserves is not provided in the information so we cannot calculate it.
WACC = (0.4 * 11.32%) + (0.2 * 7%) + (0.3 * 10%) = 9.128%
Market value cost of capital (WACC): WACC = (0.87 * cost of equity) + (0.12 * cost of preference shares) + (0.03 * cost of bonds)
WACC = (0.87 * 11.32%) + (0.12 * 7%) + (0.03 * 10%) = 10.40%
If the share price increases to £2.85 and the dividends grow by 20%, the cost of equity would decrease: Cost of equity = (D1/P0) + g D1 = the next expected dividend (28p * 1.2) = 33.6p P0 = the new share price (2.85) g = the new expected