Question 8.2: Danton plc has 10 million ordinary shares in issue with a cu...
Danton plc has 10 million ordinary shares in issue with a current market value of £2.00 per share. The expected dividend for next year is 16p per share and this is expected to grow each year at a constant rate of 4 per cent. The business also has:
■ 10.0 million 9 per cent £1 irredeemable preference shares in issue with a market price of £0.90 per share
■ £20 million of irredeemable loan capital in issue with a nominal rate of interest of 6 per cent and which is quoted at £80 per £100 nominal value.
Assume a tax rate of 20 per cent and that the current capital structure reflects the target capital structure of the business.
What is the weighted average cost of capital of the business?
The first step is to calculate the cost of the individual elements of capital. The cost of ordinary shares in Danton plc is calculated as follows:
K_{0} = \frac{D_{1}}{P_{0}} + g (see note)
= \frac{16}{200} + 0.04
= 12%
Note: The dividend valuation model has been used to calculate the cost of ordinary shares; however, the CAPM model could have been used instead if the relevant information had been available.
The cost of the preference share capital is as follows:
K_{p} = \frac{D_{p}}{P_{p}}
= \frac{9}{90}
= 10%
The cost of loan capital is:
K_{d} = \frac{I(1 – t)}{P_{d}}
= \frac{6(1 – 0.2)}{80}
= 6.0%
Having derived the cost of the individual elements, we can now calculate the weighted average cost of these elements. The WACC will be:
| (a) | (b) | (c) | (d) = (b × c) | |
| Market value £m |
Proportion of total market value |
Cost % |
Contribution to WACC |
|
| Ordinary shares (10 m × £2) (see note | 20 | 0.44 | 12 | 5.3 |
| Preference shares (10 m × £0.90) | 9 | 0.20 | 10 | 2.0 |
| Loan capital (£20 m × 0.8) | 16 | 0.36 | 6 | 2.2 |
| 45 | 1.00 | |||
| WACC | 9.5% |
Note: The market value of the capital rather than the nominal value has been used in the calculations. This is because we are concerned with the opportunity cost of capital invested, as explained earlier.