Chapter 10 • Cost of capital estimations and the discount rate
The current market prices of the business’s shares are:
Preference shares £0.65
Ordinary shares £0.80
The loan notes are irredeemable and have a market value of £100 per £100 nominal
value.
What is the weighted average cost of capital?10.4 Doverdale plc has some convertible loan notes, with a current market value of
£109 per £100 nominal value, on which it will pay interest at the rate of 12 per cent on
their nominal value in one year’s time and then annually until conversion. In four years’
time the loan notes can be converted into ordinary shares at the rate of 25 shares
per £100 nominal value of loan notes.
The cost of the loan notes is 15 per cent p.a.
What value does the market believe that the shares will have in four years’ time, if it is
assumed that conversion will take place at that time? (Ignore taxation throughout.)10.5*Da Silva plc’s shares are not traded in any recognised market. Its sole activity is
saloon car hire. It is financed by a combination of 2 million £0.50 ordinary shares and
a £1.5 million bank loan. Very recently, Mavis plc, a national car hire group, offered a
total of £5.5 million to acquire the entire equity of Da Silva plc. The bid failed because
the majority of shareholders rejected it since they wished to retain control of the
business, despite believing the offer to represent a fair price for the shares. The bank
loan is at a floating rate of interest of 10 per cent p.a. and is secured on various fixed
assets. The value of the bank loan is considered to be very close to its nominal value.
Da Silva plc’s current capital structure (by market value) represents what has been,
and is intended to continue to be, its target capital structure.
Da Silva plc’s management is in the process of assessing a major investment, to
be financed from retained earnings, in some new depots, similar to the business’s
existing ones. An appropriate cost of capital figure is required for this purpose. The
Gordon growth model has been proposed as a suitable basis for the estimation of the
cost of equity.
Recent annual dividends per share have been:Year £
1 0.0800
2 0.0900
3 0.1050
4 0.1125
5 0.1250
6 0.1350
7 0.1450
8 0.1550The business’s rate of corporation tax is expected to be 33 per cent p.a., for the fore-
seeable future.
(a) Estimate Da Silva plc’s weighted average cost of capital (WACC). (Ignore inflation.)
(b) What assumptions are being made in using the WACC figure that you have estim-
ated as the basis for the discount rate?