(a) Explain fully the effect of the use of debt capital on the weighted average cost of capital of a company. (6 marks)
(b) Millennium Investments Ltd. wishes to raise funds amounting to Sh.10 million to finance a project in the following manner:
Sh.6 million from debt; and
Sh.4 million from floating new ordinary shares.
The present capital structure of the company is made up as follows:
1. 600,000 fully paid ordinary shares of Sh.10 each
2. Retained earnings of Sh.4 million
3. 200,000, 10% preference shares of Sh.20 each.
4. 40,000 6% long term debentures of Sh.150 each.
The current market value of the company’s ordinary shares is Sh.60 per share. The expected ordinary share dividends in a year’s time is Sh.2.40 per share. The average growth rate in both dividends and earnings has been 10% over the past ten years and this growth rate is expected to be maintained in the foreseeable future.
The company’s long term debentures currently change hands for Sh.100 each. The debentures will mature in 100 years. The preference shares were issued four years ago and still change hands at face value.
Required:
(i) Compute the component cost of:
– Ordinary share capital; (2 marks)
– Debt capital (2 marks)
– Preference share capital. (2 marks)
(ii) Compute the company’s current weighted average cost of capital. (5 marks)
(iii) Compute the company’s marginal cost of capital if it raised the additional Sh.10 million as envisaged. (Assume a tax rate of 30%). (5 marks)
(Total: 20 marks)
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