Celtor plc is a property development company operating in the London area. The company has the following capital structure as at 30 November 2014.
£000
£1 ordinary shares.....................10,000
Retained profit.........................20,000
9% debentures..........................12,000
............................................42,000
The equity shares have a current market value of £3.90 per share and the current level of dividend is 20 pence per share. The dividend has been growing at a compound rate of 4 per cent per annum in recent years. The debentures of the company are irredeemable 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 company has obtained planning permission to build a new office block in a redevelopment area. The company wishes to raise the whole of the finance necessary for the project by the issue of more irredeemable 9 per cent debentures at £80 per £100 nominal. This is in line with a target capital structure set by the company where the amount of debt capital will increase to 70 per cent of equity within the next two years.
The rate of corporation tax is 25 per cent.
Required
(a) Explain what is meant by the term 'cost of capital'. Why is it important for a company to calculate its cost of capital correctly?
(b) What are the main factors which determine the cost of capital of a company?
(c) Calculate the weighted average cost of capital of Celtor plc which should be used for future investment decisions.