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Questions:
1. Andrew Inc is presently financed entirely by equity shares. The current market value is $600000. A dividend of $120000 has just been paid. This level of dividends is expected to be paid indefinitely. The project would be financed by issuing $500000 debentures at the market rate of 18%. Ignoring tax consideration:
(i) Calculate the value of equity shares and the gain made by the shareholders if the cost of equity rises to 21.6%.
(ii) Prove that weighted average cost of capital is not affected by gearing.
2. In considering the most desirable capital structure for a company, the following estimates of the cost of debt and equity capital (after tax) have been made at various levels of debt-equity mix:
Debt as a percentage of total capital employed
Cost of debt (%)
Cost of equity (%)
0
5.0
12.0
10
20
12.5
30
5.5
13.0
40
6.0
14.0
50
6.5
16.0
60
7.0
20.0
You are required to determine the optimal capital structure for the company by calculating weighted average cost of capital.
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Slow 'n Steady, Inc., has a stock price of $31, will pay a dividend next year of $2.90, and has expected dividend growth of 1.3% per year.
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