262. AMH Co (June 13 Amended)
AMH Co wishes to calculate its current cost of capital for use as a discount rate in investment appraisal. The following financial information relates to AMH Co:
Financial position statement extracts as at 31 December 20X2
|
$000 |
$000 |
Equity |
|
|
Ordinary shares (nominal value 50 cents) |
4,000 |
|
Reserves |
18,000 |
|
|
|
22,000 |
Long-term liabilities |
|
|
4% Preference shares (nominal value $1) |
3,000 |
|
7% Bonds redeemable after six years |
3,000 |
|
Long-term bank loan |
1,000 |
|
|
|
7,000 |
|
|
29,000 |
The ordinary shares of AMH Co have an ex div market value of $4.70 per share and an ordinary dividend of 36.3 cents per share has just been paid. Historic dividend payments have been as follows:
Year |
20X8 |
20X9 |
20Y0 |
20Y1 |
Dividends per share (cents) |
30.9 |
32.2 |
33.6 |
35.0 |
The preference shares of AMH Co are not redeemable and have an ex div market value of 40 cents per share.
The 7% bonds are redeemable at a 5% premium to their nominal value of $100 per bond and have an ex interest market value of $104.50 per bond.
The bank loan has a variable interest rate that has averaged 4% per year in recent years. AMH Co pays profit tax at an annual rate of 30% per year.
Required:
A. Calculate the market value weighted average cost of capital of AMH Co.
Cost of equity
The geometric average dividend growth rate in recent years:
(D0/Dn years ago) 1/n – 1
(36.3/30.9)1/4 – 1 = 1.041 – 1 = 0.041 or 4.1% per year
Using the dividend growth model:
Ke = Do (1 + g)/P0 + g
Ke = [(36.3 × 1.041)/470] + 0.041 = 0.080 + 0.041 = 0.121 or 12.1%
Cost of preference shares
As the preference shares are not redeemable:
Kp = D0/P0
Kp = 0.04/0.40 = 0.1 = 10%
Cost of debt of loan notes
The annual after-tax interest payment is 7 × 0.7 = $4.9 per loan note.
Using linear interpolation:
Year |
Cash flow |
$ |
5% DF |
PV ($) |
4% DF |
PV ($) |
0 |
Market price |
(104.5) |
1.000 |
(104.5) |
1.000 |
(104.5) |
1 – 6 |
Interest |
4.9 |
5.076 |
24.87 |
5.242 |
25.69 |
6 |
Redemption |
105 |
0.746 |
78.33 |
0.790 |
82.95 |
|
|
|
|
(1.30) |
|
4.14 |
After-tax cost of debt = 4 + [((5 – 4) × 4.14)/(4.14 + 1.30)] = 4 + 0.76 = 4.8%
Cost of debt of bank loan
If the bank loan is assumed to be perpetual (irredeemable), the after-tax cost of debt of the bank loan will be its after-tax interest rate, i.e. 4% × 0.7 = 2.8% per year.
Market values
Number of ordinary shares = $4,000,000/$0.5 = 8 million shares
|
$000 |
Equity: 8m × 4.70 = |
37,600 |
Preference shares: 3m × 0.4 = |
1,200 |
Redeemable loan notes: 3m × 104.5/100 = |
3,135 |
Bank loan (book value used) |
1,000 |
Total value of AMH Co |
42,935 |
WACC calculation
WACC = [Ve/(Ve + Vd + Vp)] × ke + [Vp/(Ve + Vd + Vp)] × kp + [Vd/(Ve + Vd + Vp)] × kd
WACC = [37,600/42,935] × 12.1 + [1,200/42,935] × 10 + [3,135/42,935] × 4.8 + [1,000/42,935] × 2.8 = 11.3%