WA Mining Ltd’s bonds will mature in four years with a total face value of $40

Question

WA Mining Ltd’s bonds will mature in four years with a total face value of $40 million, paying a

half yearly coupon rate of 6% per annum. The yield on the bonds is 14% per annum. The market

value for the company’s preference share is $6.5 per unit while the ordinary share is currently worth

$2.0 per unit. The preference share pays a dividend of $1.0 per share. The beta coefficient for the

ordinary share is 1.5 and retained earnings are expected to be more than sufficient to fund the

ordinary equity component of any new investment. The market risk premium is estimated to be 12%

per annum and the risk-free rate is 4% per annum. The company is subject to a 30% corporate tax

rate. The balance sheet values for bond and equity are shown below:

WA Mining Ltd

$ (Million)

Bonds $40

Equity:

preference shares (100,000 units) $3

Ordinary shares (10 million units) $15

a. Explain the three steps involved in the calculation of cost of capital for WA Mining.

b. Calculate WA Mining’s after-tax weighted average cost of capital.

c. WA Mining is considering raising more capital for a new project. Should the company use more

equity or debt? In your answer, discuss the effect of using more equity or debt on WA Mining’s

cost of capital.

Explanation / Answer

Market value of bonds...(divide rate by 2, multiply years by 2 to reflect semi-annual payments
semi-annual coupons: 40m * 0.06/2 = 1,200,000
PVoa = PMT [(1 - (1 / (1 + i)^n)) / i]
PVoa of the coupons = 1,200,000[(1 - (1 / 1.07^8)) / 0.07]
= 1.2m[5.9713]
= 7,165,558.21
PV of par paid at maturity: 40,000,000/1.07^8 = 23,280,364.18
PV (market value) of bonds: 30,445,922.39

BTW you don't use balance sheet values, you use market values for WACC.

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