Piper pie, which pays corporation tax at 30 per cent, has the following capital

Question

Piper pie, which pays corporation tax at 30 per cent, has the following capital structure: Ordinary shares: 1,000,000 ordinary shares of nominal value 25p per share. The market value of the shares is 49p ex div. A dividend of 7p per share has just been paid, and dividends are expected to grow by eight per cent per year for the foreseeable future. Preference shares: 250,000 preference shares of nominal value 50p per share. The market value of the shares is 32p ex div and the annual net dividend of 7.5 per cent has just been paid. Debentures: Epsilon100,000 of irredeemable debentures with a market price of Epsilon92 per Epsilon100 block. These debentures have a coupon rate of 10 per cent and the annual interest payment has just been made. Calculate the weighted average after-tax cost of capital of Piper pie. The calculation of WACC is straightforward in theory, but in practice it is not an easy task. Outline any possible difficulties that might be experienced when trying to calculate WACC. When companies are assessing new projects what conditions ought to be met in order for it to be appropriate to use their weighted average cost of capital as a discount rate?

Explanation / Answer

(a) Ordinary shares value = 1,000,000 shares x 0.25

Ordinary shares value = $250,000

Cost of ordinary shares, ke = D1/P0 + g

Cost of ordinary shares, ke = 0.07*(1.08)/0.49 + 0.08

Cost of ordinary shares, ke = 0.2343

Preference shares value = 250,000 shares x 0.50

Preference shares value = $125,000

Cost of preference shares, kp = D/P

Cost of preference shares, kp = 0.075/0.32

Cost of preference shares, kp = 0.2344

Debentures value = 100,000 x 0.92 = 92,000

Cost of debentures, kd = 10%

Total value = $250,000 + $125,000 + 92,000 = 467,000

WACC = we*ke + wp*kp + wd*kd*(1 – t)

WACC = 250,000/467000*0.2343 + 125000/467000*0.2344 + 92000/467000*0.10*(1 – 0.30)

WACC = 0.202 or 20.20%

Hence, the Weighted average cost of capital is 20.20%.

(b) (1) It does not take into consideration the floatation cost of raising the marginal capital for new projects.

(2) It is based on impractical assumption of same capital mix which is difficult to maintain.

(c) (1) Scale – The project should represent small addition to the overall company’s activities and its implementation will not affect the risk of the company.

(2) Consistency – The project should have same risk level as the existing activities of the company.

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