Celtor Ltd. is a property development business operating in London, Ontario. The business has the following capital structure as at November 30, 2011:
($000)
Common shares (10 million outstanding) ...................10,000
Retained earnings ...............................................20,000
9% debentures ...................................................12,000
42,000
The common shares have a current market value of $3.90 and the current level of dividend is $0.20 per share. The dividend has been growing at a compound rate of 4% a year in recent years. The debentures of the business are perpetual and have a current market value of $80 per $100 nominal. Interest due on the debentures at the year-end has recently been paid.
The business has obtained planning permission to build a new office block in a redeveloping area. The business wishes to raise the whole of the financing necessary for the project by issuing more perpetual 9% debentures at $80 per $100 nominal. This is in line with a target capital structure set by the business where the amount of debt will increase to 70% of common share capital within the next two years. The corporate tax rate is 25%.
Required:
(a) Explain what is meant by the term cost of capital. Why is it important for a business to calculate its cost of capital correctly?
(b) Calculate the weighted average cost of capital of Celtor that should be used for future investment decisions.