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

Cost of debt= Risk-free Rate+Beta*(Market risk Premium) =0.06+(1.4*0.05) 0.13 ie.Before tax cost of debt= 13% After-tax cost = 13%*(1-30%)= =0.13*0.7= 9.10% Cost of Preference share = Dividend/(Price-Flotation Cost)=             =6/(80-5) =               0.08 8% Cost of ordinary share Market Price=NextYear's dividend/(Cost of Equtiy- Growth Rate) 65=(3.65(1.07))/(Cost of Equity-0.07) Cost of equity= 13.01% a. Cost of debt(After-tax) 9.10% Cost of Preference share 8% Cost of ordinary share 13.01% b. Type of Capital Proportion Cost Prop.*Cost Debt 0.25 0.091 0.02275 Pref. Sh 0.15 0.08 0.012 Ord. sh 0.6 0.1301 0.07806 After-tax Weighted Av. COC 0.11281 ie. 11.28% WACC= 11.28% c. Expected IRR of the project= 15% WACC (as above) 11.28% As the returns expected from the project (15%) is more than the cost of its capital employed(11.28%) the project can be undertaken

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