Wye Ltd., a company currently specializing in the manufacture of baby napkins, is considering an investment strategy that would see it diversify into the production of adult towels. The company’s research department has developed two types of towels for female use - Type I and Type II. The company’s Finance department has evaluated the cash flows and advised that Type I towels would be more value enhancing. To launch the product, management needs ZAR 250 million, partly to acquire and install the production plant and partly to provide for permanent working capital needs. The company’s capital structure, as at end of last year, follows. Millions of ZAR Retained earnings account 300 12% Long-term debt 500 Ordinary share capital (ZAR 50 par) 450 The debt-equity ratio reported above is considered optimal. Last year, Wye earned ZAR 100 million before interest and taxes. Wye Ltd is in the 30% tax bracket and follows the policy of a constant payout ratio of 40%. Because of the new investment, earnings after taxes are expected to grow by 50% this year. However, Wye has estimated its long run growth rate in after-tax earnings as 16.5% p.a. The company uses the constant growth dividend valuation model to estimate its cost of equity. Wye Ltd. plans to finance the anticipated capital expenditure as follows. Internally generated funds will be used until exhausted, after which new equity securities will be issued. The company is considering issuing preference shares (within the optimal debt-equity ratio constraint) to enable it raise up to ZAR 90 million in new financing. Each preference share will have a par value of ZAR 50.00 and is expected to attract a fixed dividend payout of 8% per annum. The shares will be sold to investors at par and flotation costs are estimated at 1%. Because of the company’s good relations with creditors, the existing debtholders have indicated their willingness to continue providing debt capital at 12% p.a., but only up to ZAR 50 million in additional financing. Beyond that, a new 20-year bond issue will have to be made. Underwriters’ fees and other issue-related expenses are estimated at about 3% for the new issue; the coupon rate of interest is expected to be 20%. Because the current high interest rate regime, arising from the Reserve Bank of South Africa tightening of monetary policy, is expected by the financial markets to be a short-term phenomenon, the company plans to include a call provision in the bond’s indenture. As a result, it is estimated that, at the time of issue, the investors’ required rate of return on the bond would exceed the bond’s coupon rate by 200 basis points. The par value of each bond will be ZAR 1000 and coupon interest will be paid annually. Any capital requirement that cannot be raised through the above financing sources will be met from the issuance of ordinary shares. The company’s investment bankers have indicated that they would handle the issue through a firm commitment underwriting; however, because the stock market is witnessing a bear run, they would charge a fee of 4% of the issue’s gross proceeds. Further, in order to attract sufficient interest in the issue, they have advised that it be underpriced by 6.25%. Each share of the Wye stock is currently trading for ZAR 80 at the Johannesburg Securities Exchange. There will be no further issues of new ordinary shares, after this year, into the foreseeable future.

Required:

Compute the (i) Retained earnings, debt, and preference share capital breaking points. (9 marks)

(ii) Number of ordinary shares that Wye Ltd. would have to issue.(5 marks)

(iii) The cost(s) of each source of financing. (13 marks)

(iv) The marginal cost of finance and prepare MCC schedule.(8 marks)

Answer rating: 100% (QA)

To compute the retained earnings debt and preference share capital breaking points we need to determine the amount of financing that can be raised from each source before moving on to the next source ... View the full answer