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

Question

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?

Accepted Answer

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:

[latex]K_{0} = \frac{D_{1}}{P_{0}} + g[/latex] (see note)

[latex]= \frac{16}{200} + 0.04[/latex]

= 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:

[latex]K_{p} = \frac{D_{p}}{P_{p}}[/latex]

[latex]= \frac{9}{90}[/latex]

= 10%

The cost of loan capital is:

[latex]K_{d} = \frac{I(1 - t)}{P_{d}}[/latex]

[latex]= \frac{6(1 - 0.2)}{80}[/latex]

= 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.

Question 8.2: Danton plc has 10 million ordinary shares in issue with a cu...

Related Answered Questions

Iordanova plc has 12 per cent irredeemable preference shares in issue with a nominal (par) value of £1. The shares have a current market price of £0.90 (excluding dividends). What is the cost of these shares? ...

Verified Answer:

Calculate the pre-tax cost of loan capital for Lim Associates plc. (Hint: Start with a discount rate of 10 per cent.) ...

Verified Answer:

Verified Answer:

Tan and Co plc has irredeemable loan capital outstanding on which it pays an annual rate of interest of 10 per cent. The current market value of the loan capital is £88 per £100 nominal value and the tax rate is 20 per cent. What is the cost of the loan capital to the business? ...

Verified Answer:

Can you recall why this is the case? ...

Verified Answer:

Why do you think this is? ...

Verified Answer:

Lansbury plc has recently obtained a measure of its beta from a business information agency. The beta value obtained is 1.2. The expected returns to the market for the next period is 10 per cent and the risk-free rate on government securities is 3 per cent. What is the cost of ordinary shares to ...

Verified Answer:

Would it be better to hold shares with a beta value of more than 1.0 or less than 1.0 when stock market prices are generally (a) rising (b) falling? ...

Verified Answer:

Can you recall the difference between the two types of risk? ...

Verified Answer:

Avalon plc has ordinary shares in issue that have a current market price of £1.50. The dividend expected for next year is 20p per share and future dividends are expected to grow at a constant rate of 3 per cent a year. What is the cost of the ordinary shares to the business? ...

Verified Answer: