With steps please DCU Danton plc has 10 million ordinary shares in issue with a

Question

With steps please DCU 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 0.16 per share and this is expected to grow each year at a constant rate of4per 47 cent. The business has 20 million of irredeemable loan capital in issue with a nominal Tate of imterest of 10 per 10/. 9 cent and which is quoted at 80 per 100 nominal value. Assume a rate of corporation tax of 20 per cent and that the current capital structure reflects the target capital structure of the company. Required: a)What is the weighted average cost of capital of the company? b)Explain what is meant by the term cost of capital'. Why is it important for a company to calculate its cost of capital correctly?

Explanation / Answer

(a) Current Price per share = 2 euros (P0) and expected dividend next yea = D1 = 0.16 euros. Annual Growth Rate = g = 4%. Let the cost of equity be r(e)

Then using the market capitalization rate, r(e) = [D1/P0] + g = [0.16/2] + 0.04 = 0.12 OR 12%

Number of shares outstnding = 10 million. Therefore, Market Value of Equity = Current Market Price x Number of Shares Outstanding = 2 x 10 million = 20 million euros

Long Term Debt = Irreedeemable Loan Capital = 20 million euros at cost of debt = r(d) = 10%

Therefore ,weightage of equity w(e) = 0.5 and weightage of debt = w(d) = 0.5

Tax Rate = 20% = t

Therefore,, Weighted Average Cost of Capital = (1-t) x r(d) x w(d) + r(e) x w(e) = (1-0.2) x 10 x 0.5 + 12 x 0.5 = 10%

(b) Cost of Capital for a firm refers to the cost of various capital sources or financing sources used by a company to finance its own growth. It is dependent on components of financing such as debt, equity, preferred equity and retained earnings. When more than one financing component is used by a firm the overall cost of capital sources is known as the weighted average cost of capital (WACC) or simply the cost of capital. It is a weighted average of the costs of the individual financing sources with each weight being equal to the proportion of that particular financing source as part of the overall total financing. It is essential for a company to measure its cost of capital because a company generates growth only if it is able to generate returns on capital greater than its own cost of capital. In other words the cost of capital functions as a hurdle rate for taking up exansionary or growth projects by a firm. Any project generating returns exceeding the company's cost of capital should be accepted as it would create value for the firm.

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