Brecon Co has the opportunity to invest in a significant investment project. The finance director suggests the
Question:
Brecon Co has the opportunity to invest in a significant investment project. The finance director suggests the company’s existing cost of capital would be a suitable discount rate for the appraisal and has tasked you with its calculation.
Relevant capital structure details for Brecon Co as at 31 December 2020 is as follows:
Note | £ | |
Ordinary Shares (25p nominal value) | (1) | 200,000 |
Reserves | 30,000 | |
10% Preference Shares (£1 nominal value) | (2) | 250,000 |
8% Redeemable Bonds 2026 | (3) | 200,000 |
9% Irredeemable Loan Stock | (4) | 100,000 |
Notes:
- The ordinary shares have a current market price of £2.50 each (ex-div). The 2020 annual ordinary dividend has just been paid at 20.4 pence per share. Future dividends are expected to grow at the same annual rate as they have since 2017.
- Past dividends for the preceding three years were:
Year | Dividend per share |
2017 | 17.7 pence |
2018 | 18.6 pence |
2019 | 19.5 pence |
- The preference shares have a current market price of £0.80 each (ex-div) and the 2020 annual preference dividend has just been paid.
- The redeemable bonds have a current market price of £97.50 (ex-interest) per £100 nominal and the 2020 annual interest has just been paid. The bonds will be redeemed on 31 December 2026 at a 3% premium on their £100 nominal value.
- The irredeemable loan stock has a current market price of £105 (ex-interest) per £100 nominal and the 2020 annual interest has just been paid.
- The company pays corporation tax at a rate of 20% p.a.
Required:
a) What is the Weighted Average Cost of Capital (WACC) of Brecon Co.
b) Critically discuss how Brecon Co can calculate a project-specific cost of capital using CAPM as an alternative to using WACC. Your answer should highlight when it would be suitable to do so and explain the risk assumptions involved.
Managerial economics applications strategy and tactics
ISBN: 978-1439079232
12th Edition
Authors: James r. mcguigan, R. Charles Moyer, frederick h. deb harris