Q1 Grants Limited (Grants) is a company that has issued corporate bonds with a p
ID: 2818457 • Letter: Q
Question
Q1
Grants Limited (Grants) is a company that has issued corporate bonds with a par value of K100
and a coupon rate of 11%. The total Statement of Financial Position value of the bonds is
K50m. The company’s bonds are currently trading at a price of K103. Interest is payable
annually in arrears. The maturity date is in four years’ time. The company has a target capita
structure of 25% debt, 15% redeemable preference shares, 10% non-redeemable preference
shares, and 50% in ordinary equity financing. Retained earnings and contributed capital
amount to K100m.
The company has two types of preference shares in issue. There are 0.2m non-redeemable
preference shares which were issued at K100 per share and there are 0.3m redeemable shares
which were also issued at K100 and are redeemable at K100 per share. The maturity date of
the redeemable preference shares is in four years’ time. Preference dividends are payable
annually in arrears for both issues. Non-redeemable preference shares are currently priced at
K107 and the redeemable preference shares are currently priced at K104. The coupon rates are
9% for each issue and coupon payments were recently paid.
The company’s beta is 1.20 and the government treasury bill rate is 8%. The market premium
is expected to be 5.5%. The corporation tax rate is 28%.
Required:
(a) What is Grants’ after tax cost of debt?
(b) What is the cost of the two types of preference shares?
(c) What is the cost of equity?
(d) What is the company’s weighted average cost of capital?
Explanation / Answer
Answer a. After-tax cost of debt = Coupon Rate on bonds * (1- Corporation Tax rate) = 11% * (1-28%) = 7.92% (denoted as Rb)
Answer b. Cost of non-redeemable preference shares = Annual dividend on the non-redemable preference share / Market price per non-redemable preference share = Dividend rate*Face value / Market price per non-redemable preference share = 9% * K100 / K107 = 8.41% (denoted as Rnrpf)
Cost of redeemable preference shares = (Annual dividend on redeemable preference share + ((Redeemable value - Sale value)/Years for redemption))/((Redeemable value+Sale value)/2).
Since the redeemable value and sale value are the same at K100 (assuming that there are no floatation costs), the forumla equates to = (9% * K100 + ((K100-K100)/4))/((K100+K100)/2) = K9/K100 = 9.00% (denoted as Rrpf)
Answer c. Using Capital Asset Pricing Model, Cost of equity = Risk free rate (i.e. Govt. Treasury bill rate) + (Company beta) * (Market premium) = 8% + (1.2) * (5.5%) = 14.60% (denoted as Re)
Answer d. Weighted average cost of capital = WACC = We*Re + Wb*Rb + Wnrpf*Rnrpf + Wrpf*Rrpf
where,
We = Weight percentage of equity in the company's target capital structure
Wb = Weight percentage of bonds in the company's target capital structure
Wnrpf = Weight percentage of non-redeemable preference shares in the company's target capital structure
Wrpf = Weight percentage of redeemable preference shares in the company's target capital structure
Re = Cost of equity
Rb = Cost of bonds
Rnrpf = Cost of non-redeemable preference shares
Rrpf = Cost of redeemable preference shares;
Thus WACC = 50%* 14.60% + 25%* 7.92% + 10%* 8.41% + 15%* 9.00% = 11.47%
WACC = 11.47%