The finance director of Otterplc wishes to establish its cost of capital for investment appraisal purposes.The information below has been provided:
The following extract is from the statement of financial position(balance sheet)of Otterplc as at 31stDecember 2020:Non-current Liabilities:5% Irredeemable bonds£3,600,000Long term variable rate loan£2,400,000Equity:Ordinary shares (nominal value 50p)£5,000,000The current ex-interest market price of a bond is £105.The ex-dividend current market price of a share is 525p. The historic growth rate of dividends has been 8%.
The total dividend per share for 2020was 85p.LIBOR (London Interbank Offer Rate) is currently 1%, and the interest rate on the loan is 1% above this.The rate of corporation tax is 30%.Required:
a) Calculate the weighted average cost of capital (WACC) for Otterplc, using market weightings.(15 marks)
b)Explain why market weightings are preferable to book weightings when calculating a company’s WACC. (3marks)
c) Briefly evaluate the issues associated with the method used above in part a) to calculate the cost of equity.(4marks)
d)Using diagrams to illustrate your discussion, explain how Miller and Modigliani’s(1958)view of capital structure changes with the introduction of taxation.
