QUESTIONS: A. What is the weighted average cost of capital for Orange Ltd? B. With reference to the points made by your colleague, critically evaluate limitations of using CAPM and dividend growth model to estimate the cost of equity. C. The top managers would like to use the WACC from (a) to assess all new projects for the ne
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
4. You are a member of the finance staff of Orange Ltd, whose share are listed on London Stock Exchange. You have been asked to derive a weighted average cost of capital (WACC) for use in assessing a major investment in a training facility. The business’s financial statement as at 31 December 2021 shows that it has the following long-term financial capital structure:
Redeemable Debt: 5,000 redeemable debts of £100 each with 12% coupon rate
Ordinary shares: 0.5 million shares of £1 each
On 31 December 2021, the 12% redeemable debt is traded at £114 (ex-interest). It will be redeemable at par on 31 December 2022. Interest on the debt is payable annually on 31 December.
On 31 December 2021, the market price of the company’s 9% preference shares is £13.5 (cum-dividend).
On 31 December 2021, the ordinary shares are quoted at £1.21 each. The ordinary shareholders will receive a 7p annual dividend per share very soon after. Over recent years, dividends have increased at the rate of about 3% a year. The general view in the business is that this rate has been, and will continue to be, the target dividend growth rate.
The Financial Director would like you to assume a company tax rate of 30% for the foreseeable future.
After looking at your workings for WACC, a colleague expressed the view that since the
QUESTIONS:
A. What is the weighted average cost of capital for Orange Ltd?
B. With reference to the points made by your colleague, critically evaluate limitations of using CAPM and dividend growth model to estimate the cost of equity.
C. The top managers would like to use the WACC from (a) to assess all new projects for the ne
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