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Corfe Co (Mar/Jun 19)

The following information has been taken from the statement of financial position of Corfe Co, a listed company:

 

$m

$m

Non-current assets

 

50

Current assets

 

 

Cash and cash equivalents

4

 

Other current assets

16

 

 

 

20

Total assets

 

70

 

 

$m

$m

Equity and reserves

 

 

Ordinary shares

15

 

Reserves

29

 

 

 

44

Non-current liabilities

 

 

6% preference shares

6

 

8% loan notes

8

 

Bank loan

5

 

 

 

19

Current liabilities

 

7

Total equity and liabilities

 

70

The ordinary shares of Corfe Co have a nominal value of $1 per share and a current ex-dividend market price of $6.10 per share. A dividend of $0.90 per share has just been paid.

The 6% preference shares of Corfe Co have a nominal value of $0.75 per share and an exdividend market price of $0.64 per share.

The 8% loan notes of Corfe Co have a nominal value of $100 per loan note and a market price of $103.50 per loan note. Annual interest has just been paid and the loan notes are redeemable in five years’ time at a 10% premium to nominal value.

The bank loan has a variable interest rate.

The risk-free rate of return is 3.5% per year and the equity risk premium is 6.8% per year. Corfe Co has an equity beta of 1.25. Corfe Co pays corporation tax at a rate of 20%.

Investment in facilities

Corfe Co’s board is looking to finance investments in facilities over the next three years, forecast to cost up to $25 million. The board does not wish to obtain further long-term debt finance and is also unwilling to make an equity issue. This means that investments have to be financed from cash which can be made available internally. Board members have made a number of suggestions about how this can be done:

Director A has suggested that the company does not have a problem with funding new investments, as it has cash available in the reserves of $29 million. If extra cash is required soon, Corfe Co could reduce its investment in working capital.

Director B has suggested selling the building which contains the company’s headquarters in the capital city for $20 million. This will raise a large one-off sum and also save on ongoing property management costs. Head office support functions would be moved to a number of different locations rented outside the capital city.

Director C has commented that although a high dividend has just been paid, dividends could be reduced over the next three years, allowing spare cash for investment.

Required

A. Calculate the after-tax weighted average cost of capital of Corfe Co on a market value basis
B. Discuss the views expressed by the three directors on how the investment should be financed.

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