Question

A Plc is currently financed by ordinary shares with a market value of $28 million and irredeemable loan stock with a nominal value of $3 million, a market value of $119 per $100 nominal and a coupon interest rate of 4.25%. Corporation tax is 19%. The beta value of the ordinary shares is 1.6, the market rate of return is 4% and the risk free rate of return is 2.2%.

a) Calculate the current after tax weighted average cost of capital for A Plc, as a percentage correct to one decimal place.One industry A Plc is considering moving into is furniture manufacturing. Research by A plc has found that a major producer of furniture has an equity beta of 1.5 and capital gearing of 60% equity and 40% debt by market values. The current capital gearing of A plc would not change if it moved into furniture manufacturing.
b) Estimate the cost of capital A Plc should use as the discount rate for its proposed investment in furniture manufacturing. State clearly any assumptions you make.tax weighted average cost of capital for A Plc, as a percentage correct to one decimal place

Answer 1

The current after-tax weighted average cost of capital for A Plc is 4.9%, calculated using the CAPM for equity and adjusting the interest on debt for taxes. For the investment in furniture manufacturing, the estimated cost of capital is 4.7%, using the industry beta of 1.5 and assuming unchanged capital structure.

Step-by-step explanation:

The student is asking for the calculation of the current after-tax weighted average cost of capital (WACC) for A Plc and the estimation of the cost of capital for a potential investment in furniture manufacturing. To calculate the WACC, we first need to determine the market values of equity and debt, then calculate the cost of equity using the Capital Asset Pricing Model (CAPM), and figure out the after-tax cost of debt. Finally, we combine these to find out the WACC.

Cost of equity = Risk-free rate + Beta x (Market rate of return - Risk-free rate)
= 2.2% + 1.6 x (4% - 2.2%) = 5.08%

The market value of the debt is the nominal value multiplied by the market price, which is $3,000,000 x ($119/$100) = $3,570,000. The after-tax cost of debt is calculated by taking the interest rate and adjusting it for corporation tax. It is 4.25% x (1 - 19%) = 3.4425%.

The WACC is then calculated as follows:
WACC = (Equity / (Equity + Debt)) x Cost of equity + (Debt / (Equity + Debt)) x After-tax cost of debt
= ($28,000,000 / ($28,000,000 + $3,570,000)) x 5.08% + ($3,570,000 / ($28,000,000 + $3,570,000)) x 3.4425%
= 4.8772%

For calculating the cost of capital for the furniture manufacturing investment, we assume that A Plc’s market rate and capital structure remain unchanged. We use the beta provided for the industry peer (1.5) and apply CAPM.
Cost of equity for furniture manufacturing = Risk-free rate + Beta x (Market rate of return - Risk-free rate)
= 2.2% + 1.5 x (4% - 2.2%) = 4.9%

Assuming the after-tax cost of debt remains the same (3.4425%), and using the same proportions, we obtain the WACC for the new investment.
WACC for furniture manufacturing = ($28,000,000 / ($28,000,000 + $3,570,000)) x 4.9% + ($3,570,000 / ($28,000,000 + $3,570,000)) x 3.4425%
= 4.7111%