Problem 1

Delaware plc
Extracts from Delaware plc's most recent balance sheet are as follows:

Long Term Debt £

12% Irredeemable Debt 4m

Owner’s Equity
Ordinary Share Capital (£1 per share) 8m
Share Premium Account 2m
Profit & Loss Reserves 6m
16m
Problem 1

An annual ordinary dividend of 20p per share has just been paid. In the past,
ordinary dividends have grown at a rate of 10% per annum and this rate of growth is
expected to continue. Annual interest has recently been paid on the debt. The
ordinary shares are currently quoted at £2.75 and the debts are traded at 80% of its
nominal value.

The rate of corporation tax is 30%.

Required

Calculate Delaware's Weighted Average Cost of Capital

 Irredeemable Debt Vs. Redeemable Debt

Irredeemable Debt: Irredeemable debt is debt that has no

specific redemption date or maturity period. The issuing
authority or entity pays a specified interest rate periodically
but provides no data on when principal will be returned. In
many cases the principal is never paid.
Redeemable Debt: A redeemable debt (or callable debt), is
a bond that a borrower can repay before its maturity. The
borrower usually pays a premium, or fee, to the bondholder
when a debt is redeemed.
Ordinary Share Capital: Ordinary share capital is the amount of
capital invested by investors in exchange for shares. The investors
who contribute to this ordinary share capital are called shareholders.

Share Premium Account: A share premium account appears on the

balance sheet, and is the amount of money paid for a share above the
cost of the share.

Profit & Loss Reserves: A reserve that contains the balance of

retained earnings to carry forward. It is fully distributable and shown
as part of shareholders’ reserves on the balance sheet.
Solution 1:Delaware plc

• 11

Cost of Equity= ke
Present market value, P0 = 2.75×100 = 275 pence
Growth rate, g= 10%
Paid dividend, D0=20 pence

Ke =

= 18%
Solution 1
Delaware plc
As the debt is irredeemable, it will act like perpetuity
So, Present value of debt = Present value of perpetuity =
Present value of irredeemable debt =
Before tax Cost of irredeemable debt(Kd)
=
=
= = 15%
After-tax cost of irredeemable debt = 15% (1 – tax rate)
= 15% (1-.30)
= 10.5%
WACC=Weight of Equity * Cost of Equity + Weight of Debt * Cost of Debt * (1-tax rate)
Weight of Equity & Debt:
MV of Equity = No. of Shares*MV Per Share
= £ 8m*2.75
= £22m
MV of Debt = Face Value of Debt*0.80
= £ 4m*0.80
= £ 3.2
Total value of fund = £22m+3.2m=25.2m
So, Weight of Equity: =

Weight of Debt: =
Solution 1
Delaware plc

WACC=Weight of Equity * Cost of Equity + Weight of Debt * Cost of Debt * (1-tax rate)

* Cost of Equity + * Cost of Debt * (1-tax rate)

= 0* 0.18 + 0.15*(1-0.30)

= 17.03%
Solution 1

Cost of
Weighted
Market Value Weight Capital
Cost
%
Equity £22m 87% 18 15.7
Debt £3.2m 13% 15 1.3
Total (D+E) £25.2m 100% WACC = 17.0%
Problem 2

You have been called in as a consultant for Herbert plc, a sporting goods retail firm,
which is examining its debt policy. The firm is currently has a balance sheet as
follows:

All amounts in £m

Fixed assets £500 Long term bonds £100

Current assets £100 Equity £500
Total £600 Total £600
Problem 2
The firm's income statement is given as follows (all in £m):
Revenues £250
Cost of goods sold £175
Depreciation £25
EBIT £50
Long term interest £10
Earning before tax £40
Taxes £16
Net Income £24

The firm currently has 100m shares outstanding, selling at a market price of £5 per
share and the bonds are selling at their book value. The firm's current beta is 1.12,
the rate of return on government treasury bonds is 7% and the market risk premium
is 5.5%.
Problem 2

a. What is the firm's current cost of equity?

b. What is the firm's current cost of debt? (You may assume the rate of corporation
tax is 40%).
c. What is the firm's current weighted average cost of capital?
d. Assume that management of Herbert plc is considering doing a debt-equity swap
(i.e., borrowing enough money to buy back 70m shares of stock at £5 per share).
It is believed that this swap will lower the firm's rating to C and raise the interest
rate on the company's debt to 15% and the beta of equity is expected to increase
to 2.8. What is the firm's new weighted average cost of capital?
Solution 2
Herbert plc

a. Current cost of equity = 7% + 1.12(5.5%) = 13.16%

b. Current pre-tax cost of debt = Interest Expenses/Market value of debt = 10/100

= 10%
The after tax cost of debt = 10% (1 - 0.4) = 6%.

c. The firms current cost of capital (WACC) = D/V r debt (1 - T) + E/V requity
Where, rdebt= Pre-tax cost of debt and
rdebt(1 - T) = After-tax cost of debt.
Thus, WACC = 13.16% (500/600) + 6% (100/600) = 11.97%.
Solution 2

C) WACC= Weight of Equity * Cost of Equity +

Weight of Debt * Cost of Debt * (1-tax rate)
Here,
Weight of Equity & Debt:

MV of Equity = No. of Shares*MV Per Share

= 100*5
= £ 500

MV of Debt = £ 100 (given)

So, Weight of Equity: =

Weight of Debt: =
Solution 2

Cost of Weighted
Market Value Weight
Capital Cost
Equity £500 83.33% 13.16% 10.97%
Debt £100 16.67% 6% 1.00%
Total (D+E) £600 100% WACC = 11.97%
Solution 2
Herbert plc

d. If the firm borrows £350 million and buys back shares

New MV debt = £450m
New MV equity = £150m
New Beta = 2.80 [Previous beta= 1.12]
The cost of new equity = 7% + 2.80 (5.5%) = 22.40%
The after tax cost of debt = 15% (1 - 0.4) = 9%
New WACC = 22.40% (150/600) + 9% (450/600) = 12.35%

[Previous WACC = 13.16% (500/600) + 6% (100/600) = 11.97%]

 Cost of Weighted
Market Value Weight
Capital Cost
Equity £500 83.33% 13.16% 10.97%
Debt £100 16.67% 6% 1.00%
Total (D+E) £600 100% WACC = 11.97%

Cost of Weighted
Market Value Weight
Capital Cost
Equity £150 25% 22.40% 5.6%
Debt £450 75% 9% 6.75%
Total (D+E) £600 100% WACC = 12.35%
Problem 3 : West Ltd
West Ltd is an unquoted company. The recently appointed Finance Director has
asked for your assistance in obtaining a cost of capital that West Ltd can use to
appraise its long-term investment opportunities.

You have been provided with the following information:

 2 million 25p ordinary shares valued at 87p

 The annual dividend of £180,000 - which represents 70% of the amount that
was available for distribution, has just been paid. The company expects to
achieve a rate of return of 26% on its retained profits.

 1 million 9% preference shares of 10p valued at £80,000 including dividend.

Problem 3
 £1m 8% irredeemable debentures. Debenture holders require a rate of return of
10%.
 The rate of corporation tax is 30%.

Required
Calculate for West Ltd its
(a) cost of equity
(b) cost of preference shares
(c) market value of debentures
(d) cost of debentures
(e) weighted average cost of capital
Solution 3 : West Ltd
Plowback ratio is the percentage of income that a company reinvests into its own operations.

Cost of Equity(Ordinary Share):

g = rate of return on equity * plowback ratio
= 26% * 30%
=7.8%
Cost of Equity, Ke= + g

= 19.0%
Solution 3
West Ltd
Cost of Preference Share
In case of preference share,
Number of Shares= 1M
Price per share(Face Value)=10p
Dividend rate=9%

Preferred dividend = Number of Shares*Price per Share(Face Value*Dividend Rate)

=£1M*.10*9%=£9000

Market value of preferred Share + Preferred dividend= 80,000

=>Market value of preferred Share + £9,000=£80,000
=>Market value of preferred Share=£71,000

Cost of Preference Share = == =12.7%

Solution 3

West Ltd
Market value of debentures (similar to perpetuity in this case):
Market Value Of Debentures =
=

=
Here,
=£0.8M Coupon Rate: 8%
Required rate of Return: 10%
Cost of debentures after tax= 10% (1 - tax rate) = 10% (1 - 0.3) = 7%
WACC=Weight of Equity * Cost of Equity + Weight of Preferred Share* Cost of Preferred Share +
Weight of Debt * Cost of Debt * (1-tax rate)
Here,
Weight of Equity & Debt:
MV of ordinary share(Equity) = No. of Shares*MV Per Share
= £2M*87p
= £1.74M
Market value of Preferred Share(PS) =£71,000=£.071M
MV of Debt =£.8M

So, Weight of Equity(Ordinary Share): =

Weight of Preferred Share: =

Weight of =
Solution 3
West Ltd
e) WACC:
Market Value % Cost of Weighted Cost
Capital
%

Equity(E) £1.740M = 66.67% 19 66.67%*19%=12.7%

Preference £0.071M = 2.7% 12.7 2.7%*12.7%-=0.34%

shares(PS)

Debt £0.80M = 30.6% 7 30.6%*7%=2.14%

Total (D+PS+E) £2.611M WACC = 15.18%