During the past three years, Tysseland Communications Limited (TCL) has been con

Question

During the past three years, Tysseland Communications Limited (TCL) has been constrained by the high cost of capital to fund for many of its investments. Recently, capital costs have been declining steadily causing the company to consider a major project. You are appointed as an assistant to the finance manager and your task is to calculate the cost of capital for the new project. TCL has the following capital structure, which it considers to be optimal: debt (25%), preference shares (15%), and ordinary shares (60%). TCL's tax rate is 30%, and investors expect earnings and dividends to grow at a constant rate of 7% per year into the future. TCL paid a dividend of $3.65 per share last year, and its share currently sells at a price of $65 per share. Long term Government bonds yield 6% per year and the market risk premium is 5% per year. An analyst has confirmed that TCL's beta is 1.40. The company has the following terms that apply to new security offerings: • Preference shares: New preference shares could be sold to the public at a price of $80 per share, with a dividend of $6. Flotation costs of $5 per share would be incurred. • Debt: Debt could be sold at an interest rate of 8% per year. • Ordinary shares: New common equity will be raised only by retaining earnings. Required:

a. Find the individual costs of the following sources of finance (5 marks each): • Debt, • Preference share, and • Ordinary share

b. Calculate the company’s after-tax weighted average cost of capital (5 marks).

c. The finance manager confirmed that the project would generate an IRR of 15% per year. Based on your calculation in b.), should this project be undertaken by the company? Discuss your recommendation and support with relevant calculations (5 marks).

Explanation / Answer

Part A)

The cost of each source of finance is calculated as follows:

After-Tax Cost of Debt = Interest Rate*(1-Tax Rate) = 8*(1-30%) = 5.60%

________

Cost of Preferred Stock = Annual Dividend/(Current Selling Price - Flotation Cost)*100 = 6/(80-5)*100 = 8%

________

We will have to calculate the cost of ordinary share with the use of both DCF technique and CAPM method and take the average of two.

Cost of Common Share (DCF) = D1/Current Selling Price + Growth Rate = 3.65*(1+7%)/65 + 7% = 13.01%

Cost of Common Share (CAPM) = Risk Free Rate + Beta*(Market Risk Premium) = 6 + 1.40*5 = 13%

Cost of Common Share (Average) = (13.01% + 13%)/2 = 13%

_________

Part B)

The weighted average cost of capital can be calculated with the use of following formula:

WACC = Weight of Debt*After-Tax Cost of Debt + Weight of Preferred Stock*Cost of Preferred Stock + Weight of Equity*Common of Equity

_______

Using the information provided in the question and values calculated in Part A) above, we get,

WACC = 25%*5.60% + 15%*8% + 60%*13% = 10.40%

_________

Part C)

Yes, the project should be undertaken by the company as the IRR of 15% expected from the project is greater than the cost of capital of 10.40% calculated in Part B).

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