Reference no: EM132194233
Question - RunRig Ltd. is an investment company with the following balance sheet:
Long-term debt
|
$
|
Bonds: Par $100, annual coupon 10% p.a., 5 years to maturity
|
3,000,000
|
Equity
|
|
Preference shares
|
1,000,000
|
Ordinary shares
|
1,000,000
|
Total
|
5,000,000
|
Notes: The Company's bank has advised that the interest rate on any new debt finance provided for the projects would be 9% p.a. if the debt issue is of similar risk and of the same time to maturity and coupon rate.
There are currently 100,000 preference shares on issue, which pay a dividend of $1.20 per year. The preference shares currently sell for $8.65.
The company's existing 500,000 ordinary shares currently sell for $2.95 each. You have identified that RunRig has recently paid a $0.25 dividend. Historically, dividends have increased at an annual rate of 4% p.a. and are expected to continue to do so in the future.
The company's tax rate is 30%.
Your client wishes to understand, with the use of workings, the following aspects of this company and states that their required rate of return for the investment in a company with similar characteristics to RunRig would be 1% p.a.
Advise the client on whether you believe this to be a good or bad investment and the rationale for investment (or not investing)
a) What are the assumptions underlying the use of a dividend growth model for the estimation of a company's cost of equity?
b) Determine the market value proportions of debt, preference shares and ordinary equity comprising the company's capital structure.
c) Calculate the after-tax costs of capital for each source of finance.
d) Determine the after-tax weighted average cost of capital for the company.