Syndicate Ltd. is re-evaluating the rate of return demanded by its investors for new projects with the following projects being reviewed by the board for possible investment: Investment Investment Cost ($) Rate of Return (%) A 1,500,000 15 B 2,000,000 12 C 5,000,000 9 D 750,000 6 The latest balance sheet for Syndicate Ltd shows: Long Term Debt Book Value ($) Bonds: Issued at par: $100 5,000,000 Annual coupon of 6% 4 years to maturity Equity Preference Shares: 1,000,000 100,000 shares issued Ordinary Shares: 4,000,000 1,000,000 shares issued The company’s bank has advised that the interest rate on any new debt finance provided for new projects would be 8% p.a. The company’s preference shares currently sell for $9.35 each, and pay a dividend of $1.10 per share. The company’s existing ordinary shares sell for $4.15 each and pay a dividend per share of $0.55 , which has just been paid to shareholders. Historically, dividends have increased at an annual rate of 2% p.a. and are expected to continue to do so in the future. Syndicate’s company tax rate is 30%. Determine the market value proportions of debt, preference shares and ordinary equity comprising the company’s capital structure. Briefly detail why market values should be used to calculate the weighted cost of capital Calculate the after-tax costs of capital for each source of finance. Determine the after-tax weighted average cost of capital for the company. 5. Determine which investments should be made.
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
Syndicate Ltd. is re-evaluating the
|
Investment |
Investment Cost ($) |
Rate of Return (%) |
|
A |
1,500,000 |
15 |
|
B |
2,000,000 |
12 |
|
C |
5,000,000 |
9 |
|
D |
750,000 |
6 |
The latest balance sheet for Syndicate Ltd shows:
Long Term Debt Book
Bonds: Issued at par: $100 5,000,000
Annual coupon of 6%
4 years to maturity
Equity
100,000 shares issued
Ordinary Shares: 4,000,000
1,000,000 shares issued
The company’s bank has advised that the interest rate on any new debt finance provided for new projects would be 8% p.a.
The company’s preference shares currently sell for $9.35 each, and pay a dividend of $1.10 per share.
The company’s existing ordinary shares sell for $4.15 each and pay a dividend per share of $0.55 , which has just been paid to shareholders. Historically, dividends have increased at an annual rate of 2% p.a. and are expected to continue to do so in the future.
Syndicate’s company tax rate is 30%.
- Determine the market value proportions of debt, preference shares and ordinary equity comprising the company’s capital structure.
- Briefly detail why market values should be used to calculate the weighted cost of capital
- Calculate the after-tax costs of capital for each source of finance.
- Determine the after-tax weighted average cost of capital for the company.
5. Determine which investments should be made.
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