Nolimits Ltd. is at the present time an all equity financed company with a cost of capital of 12.5%.  The manager, Ms Doverdecash (Ann to her friends), is considering whether it might be desirable to issue some debt capital.  Debt is currently yielding 5% p.a. and may be assumed to be risk free for all firms who issue it (or who wish to issue it).  To this end Ms Doverdecash has collected data on four other companies, each of which falls into one of two industrial sectors (A and B).  The data she has collected are summarised below:

                               Industrial      Leverage    Expected growth         Price  Dividend
      Company Sector  Ratio     of earnings/divs     per share  per share

           X     A     0                 0           £1     10p
           Y     A   0.5                 0           £2     30p
           T     B     0                 0           £2     30p
           U     B   0.2                 0           £2     35p

Where Leverage Ratio = Debt/(Debt +Equity)

There is no taxation.

(i)Calculate the cost of Equity capital, the cost of Debt capital and the WACC for the four companies.

(ii)Given your answers to (i), advise Ms Doverdecash on the capital structure policy which she should follow.  Explain and justify your answer by reference to relevant economic theory.

(iii)Indicate how your advice might be modified if corporate taxes were introduced into the analysis.

Answer rating: 100% (QA)

i To calculate the cost of equity capital Ke for each company we can use the dividend discount model DDM Ke Dividend Price For Company X Ke 10p 1 010 ... View the full answer