Trexon plc is a major oil and gas exploration business that has most of its operations in the Middle East and South-East Asia. Recently, the business acquired rights to explore for oil and gas in the Gulf of Mexico. Trexon plc proposes to finance the new operations from the issue of ordinary shares. At present, the business is financed by a combination of ordinary share capital and loan capital. The ordinary shares have a nominal value of £0.50 and a current market value of £2.60. The current level of dividend is £0.16 per share and this has been growing at a compound rate of 6 per cent a year in recent years. The loan capital is irredeemable and has a current market value of £94 per £100 nominal. Interest on the loan capital is at the rate of 12 per cent and interest due at the year end has recently been paid.

At present, the business expects 60 per cent of its finance to come from ordinary share capital and the rest from loan capital. In the future, however, the business will aim to finance 70 per cent of its operations from ordinary share capital.

When the proposal to finance the new operations via the rights issue of shares was announced at the annual general meeting of the business, objections were raised by two shareholders present, as follows:

■ Shareholder A argued: ‘I fail to understand why the business has decided to issue shares to finance the new operation. Surely it would be better to reinvest profit, as this is, in effect, a free source of finance.’

■ Shareholder B argued: ‘I also fail to understand why the business has decided to issue shares to finance the new operation. However, I do not agree with the suggestion made by Shareholder A. I do not believe that shareholder funds should be used at all to finance the new operation. Instead, the business should issue more loan capital, as it is cheap relative to ordinary share capital and would, therefore, reduce the overall cost of capital of the business.’

Tax is at the rate of 35 per cent.

Required:

(a) Calculate the weighted average cost of capital of Trexon plc that should be used in future investment decisions.

(b) Comment on the remarks made by:

(i) Shareholder A

(ii) Shareholder B.