XYZ Company is a listed company that plans to spend K10m on expanding its existing business. It has been suggested that the money could be raised by issuing 9% loan notes redeemable in ten years’ time. Current financial information on XYZ is as follows.

Income statement information for the last year:

k000

Profit before interest and tax 7,000

Interest (500)

Profit before tax 6,500

Tax (1,950)

Profit for the period 4,550

Balance sheet for the last year:

K000 K000

Non-current assets 20,000

Current assets 20,000

Total assets 40,000

Equity and liabilities

Ordinary shares, par value K1 5,000

Retained earnings 22,500

Total equity 27,500

10% loan notes 5,000

9% preference shares, par value $ 2,500

Total non-current liabilities 7,500

Current liabilities 5,000

Total equity and liabilities 40,000

The current ordinary share price is K4.50 per share. An ordinary dividend of K0.35 per share has just been paid and dividends are expected to increase by 4% per year for the foreseeable future. The current preference share price is K0.76. The loan notes are secured on the existing non-current assets of XYZ and are redeemable at

par in eight years’ time. They have a current market price of K105 per K100 loan note (assume before tax cost is now 10%). XYZ pays tax on profits at an annual rate of 30%.

The expansion of business is expected to increase profit before interest and tax by 12% in the first year.

Average sector ratios:

Financial gearing: 45% (prior charge capital divided by equity capital on a book value basis)

Interest coverage ratio (EBIT/I): 12 times

Required:

1. Calculate the current weighted average cost of capital of XYZ.

2. Evaluate and comment on the effects, after one year, of the loan note issue and the expansion of business on the following ratios:

1. interest coverage ratio;

2. financial gearing;

earnings per share.