Calculate the after-tax costs of capital for each source

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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.

Reference no: EM132194233

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