2. Your client wishes for you to evaluate the current structure of Homestarter Ltd. (a small investment company) in an aim to identify the current returns required for the company. This company has the following balance sheet and details: Long-term debt $ Bonds: Par $100, annual coupon 8% p.a., 6 years to maturity 5,000,000 Equity Preference shares 1,000,000 Ordinary shares 10,000,000 Total 16,000,000 Notes: The company's bank has advised that the interest rate on any new debt finance provided for the projects would be 7% p.a. if the debt issue is of similar risk and of the same time to maturity and coupon rate. There are currently 150,000 preference shares on issue, which pay a dividend of $1.30 per year. The preference shares currently sell for $8.20. The company's existing 600,000 ordinary shares currently sell for $2.85 each. You have identified that Homestarter has recently paid a $0.28 dividend. Historically, dividends have increased at an annual rate of 3% p.a. and are expected to continue to do so in the future. The company's tax rate is 25%. Your client wishes to understand, with the use of workings, the following aspects of this company and states that their required rate of return for the investment in a company with similar characteristics to Homestarter would be 10% p.a. Advise the client on whether you believe this to be a good or bad investment and the rationale for investment (or not investing). a) What are the assumptions underlying the use of a dividend growth model for the estimation of a company's cost of equity? (2 marks) b) Determine the market value proportions of debt, preference shares and ordinary equity comprising the company's capital structure. (7 marks) c) Calculate the after-tax costs of capital for each source of finance. (3 marks) d) Determine the after-tax weighted average cost of capital for the company. (3 marks) e) Provide recommendation to your client. (2 marks) 2. Your client wishes for you to evaluate the current structure of Homestarter Ltd. (a small investment company) in an aim to identify the current returns required for the company. This company has the following balance sheet and details: Long-term debt $ Bonds: Par $100, annual coupon 8% p.a., 6 years to maturity 5,000,000 Equity Preference shares 1,000,000 Ordinary shares 10,000,000 Total 16,000,000 Notes: The company's bank has advised that the interest rate on any new debt finance provided for the projects would be 7% p.a. if the debt issue is of similar risk and of the same time to maturity and coupon rate. There are currently 150,000 preference shares on issue, which pay a dividend of $1.30 per year. The preference shares currently sell for $8.20. The company's existing 600,000 ordinary shares currently sell for $2.85 each. You have identified that Homestarter has recently paid a $0.28 dividend. Historically, dividends have increased at an annual rate of 3% p.a. and are expected to continue to do so in the future. The company's tax rate is 25%. Your client wishes to understand, with the use of workings, the following aspects of this company and states that their required rate of return for the investment in a company with similar characteristics to Homestarter would be 10% p.a. Advise the client on whether you believe this to be a good or bad investment and the rationale for investment (or not investing). a) What are the assumptions underlying the use of a dividend growth model for the estimation of a company's cost of equity? (2 marks) b) Determine the market value proportions of debt, preference shares and ordinary equity comprising the company's capital structure. (7 marks) c) Calculate the after-tax costs of capital for each source of finance. (3 marks) d) Determine the after-tax weighted average cost of capital for the company. (3 marks) e) Provide recommendation to your client. (2 marks)