STW Co's Finance Director has heard that the company's market value will increase if the company's weighted

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Question:

STW Co's Finance Director has heard that the company's market value will increase if the company's weighted average capital cost decreases. The company listed on the stock exchange has 100 million shares in question and the present ex div common stock price of $2.50 per share. STW Co also has bonds with a book value of $60 million and a current ex-interest price of $104 per 100 dollars bond. STW Co's current debt after-tax cost is 7%, and the tax rate is 30%.

The recent dividends per share of the company are as follows.

Year 2010 2011 2012 2013 2014

Dividend per share (cents) 19.38 20.20 20.41 21.02 21.80

The finance director proposes to decrease the weighted average cost of capital of STW Co, and hence increase its market value, by issuing $40m of bonds at their nominal value of $100 per bond. These bonds would pay annual interest of 8% before tax and would be redeemed at a 5% premium to nominal value after 10 years.

Calculate the market value after-tax weighted average cost of capital of STW Co in the following circumstances:

(i) Before the new issue of bonds takes place.

(ii) After the new issue of bonds takes place.Comment on your findings.

(b) Discuss the director's view that issuing traded bonds will decrease the weighted average cost of capital of STW Co and thereby increase the market value of the company.