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Western Communications Ltd's bonds will mature in five years with a total face value of $50 million, paying a half yearly coupon rate of 10% per annum. The yield on the bonds is 15% per annum. The market value for the company's preference share is $5.0 per unit while the ordinary share is currently worth $3.0 per unit. The preference share pays a dividend of $0.5 per share. The beta coefficient for the ordinary share is 1.2 and retained earnings are expected to be more than sufficient to fund the ordinary equity component of any new investment. The market risk premium is estimated to be 13% per annum and the risk-free rate is 4% per annum. The company is subject to a 30% corporate tax rate. The balance sheet values for bond and equity are shown below:
$ (Million)
Bonds $50
Equity:
preference shares (200,000 units) $3
Ordinary shares (10 million units) $15
a. Explain the three steps involved in the calculation of cost of capital for Western Communications.
b. Calculate Western Communications' after-tax weighted average cost of capital.
c. Western Communications is considering raising more capital for a new project. Should the company use more equity or debt? In your answer, discuss the effect of using more equity or debt on the company's cost of capital.
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