Pacific Coconuts Ltd. is an investment company that is considering expanding their business, and as such, is reviewing their current financing mix and the costs of their sources of finance.
The latest balance sheet for the company shows:
Long-term debt $
Bonds: Par $100, annual coupon 9% p.a., 6 years to maturity 3,000,000
Equity
Preference shares (500,000 shares outstanding, 40 cents per share dividend) 2,000,000
Ordinary shares (10,000,000 shares issued) 10,000,000
Total 15,000,000
The company’s debt (bonds) currently sell for $104.62, while the preference shares currently sell for $3.89
Pacific Coconuts wishes to re-estimate the value of their shares based on historical cost of equity and dividend growth values. Historically, the cost of equity averages 15% p.a., while the growth of dividends is estimated at 4% per year and is expected to continue to do so in the future. Pacific Coconuts has recently paid a dividend of 15 cents.
The company's tax rate is 30%.
(a) Using current market and expected (calculated) values, determine the market value proportions of debt, preference shares and ordinary equity comprising Pacific Coconuts capital structure.
(b) Calculate the after-tax costs of capital for each source of finance.
(c) Determine the after-tax weighted average cost of capital for the company.
(d) Using your knowledge of the costs of finance capital, identify what you expect to happen to the weighted average cost of capital if additional costs are incurred in the securing new equity finance? If you need you can show the expectation numerically using the answers from (a) – (c).