Question: The finance director of Kingsize plc is currently reviewing the capital structure of his company. He is convinced that the company is not financing itself in a way that minimises its cost of capital (WACC). The company's financing as at 1 January 2006 is as follows:
The finance director feels that by issuing more debt the company will be able to reduce its cost of capital. He proposes the issue of £15m of 11 per cent debentures. The debentures will be sold at a 5 per cent premium to their par value and will mature after seven years. The funds raised will be used to repurchase ordinary shares which the company will then cancel. He expects the repurchase will cause the company's share price to rise to £2.78 and the future dividend growth rate to increase by 20 per cent (in relative terms). He expects the price of the 10 per cent debentures to be unaffected, but the price of the preference shares to fall to 68p. Corporation tax stands at 30 per cent.
(a) Calculate the current cost of capital (WACC) for Kingsize plc.
(b) Given the proposed changes to Kingsize's capital structure, recalculate the company's cost of capital to reflect these changes and comment on the finance director's projections.
(c) Identify and discuss possible inaccuracies that may occur with the finance director's estimates.