# Sources of capital

Questions for Seminar 3

1. In January 2010 Tawny Owl Plc issued a 1 for 11 rights issue. At the time the

market price of the shares was 54.5 pence each, the rights price was set at

45p per share. Calculate the theoretical share price after the rights issue and

the value of the right.

2. Raven Plc is a geared company with a debt to equity ratio of 1:2. Its cost of

equity is 15% and the pre-tax cost of debt is 8%. Corporation tax is 30%.

Calculate the current weighted average cost of capital.

3. Rook Plc is financed by the following three types of capital:

• 1 million ordinary shares (nominal value 50p) with a current market value

of £5.20 cum. div. The current dividend of 20p per share is due to be

paid shortly. The dividend has grown steadily in the past at a compound

annual rate of 15% and this is expected to continue indefinitely

• 200,000 £1 preference shares paying an 8% dividend. The current exdiv market price of the preference shares is 50p each.

• £2m of company bonds. The bonds are redeemable in 10 years time

and have a coupon rate of 10%. The bonds are currently trading at a

discount of 36% of their nominal value..

Rook is considering a new project having the same risk characteristics as

existing projects, which would require an immediate outlay of £150,000 and

would produce annual after tax cash inflows of £30,000 indefinitely.

Rook Plc pays Corporation Tax at 30%. (This rate is not expected to change.)

Required:

Calculate the cost of capital of Rook and advise whether the new project is

worthwhile.

4. Company C has just paid a dividend of 17.5p per share. If the ex-dividend

market price of the share is 162p, the return on a treasury bond is 5.25% and

the market risk premium 4.70% calculate the beta of Company C.

5. The following extracts are from the most recent financial statements for Unicorn Plc.

£

Ordinary Shares (25p) 1,000,000

6.5% Preference Shares (£1) 800,000

7% Debentures 2010 2,500,000

Dividends per share:

2003 2002 2001 2000 1999

3.0p 3.0p 2.8p 2.75p 2.5p

The 2003 ordinary dividend has just been paid and the current market price of the shares is 230p, the current market price of the preference shares is 110p

and the debentures are currently trading at par. Unicorn is liable to corporation

tax at the rate of 30%. The current return on Government Bonds is 4.5% and

the market risk premium is 4.25%. The beta of Unicorn Plc is 0.78.

Required:

a] Calculate the cost of equity using the dividend growth model.

b] Calculate the required rate of return on equity using the CAPM.

c] Calculate the WACC of the company using the cost of equity calculated in

[a].

d] Calculate the WACC of the company using the required rate of return on

equity calculated in [b] as the cost of equity.

e] Explain the reasons for any difference in the two WACCs you have

calculated and explain which of the two you would recommend the

company to use as the discount rate in project appraisal.

6. Fully explain the theory on capital structure that he presented, along with

Merton Miller, in 1961. Your answer should include the original assumptions

and the subsequent adaptations they made to the model.

7. Explain Myer’s pecking order theory of capital structure.

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