Reference no: EM132988186

Question - You are a member of the finance staff of Finance Consulting plc, whose shares are listed on the London Stock Exchange. You have been asked to derive a weighted average cost of capital (WACC) for use in assessing a major investment in a training facility in China. The business's statement of financial position at 31 January this year showed the following long-term financing:

120 million ordinary shares of $0.25 each at par

Retained earnings $55 million

9% long-term loan $30 million

At 31 January this year, the shares were quoted at $1.21 per share, and the business had declared a dividend of $ 0.052 per share. Over recent years, dividends have increased at the rate of about 5% a year. The general view in the business is that this rate has been, and will continue to be, the target dividend growth rate.

The long-term loan is not traded on a stock exchange and is due to be redeemed at par on 31 January, two years later than the above statement of financial position date. Interest is payable annually on 31 January. You have looked at the current prices of similar, but traded, loan notes of comparable companies and you have concluded that the cost of Finance Consulting plc's loan notes is 5.5% per annum.

After looking at your workings for WACC, a colleague expressed the view that since the cost of equity is linked to dividends, and the cost of borrowing is lower than that for equity, a business can reduce its WACC by paying smaller dividends. He went on to say that he finds it odd that the business should have a target dividend growth rate. He also asked why account needed to be taken of the loan not being traded.

The business's corporation tax rate is 30%.

Required -

(a) Determine the business's WACC at 31 January this year.

(b) Discuss the points made by your colleague.

(c) Outline reasons why the WACC determined in (a) may not be suitable for assessing the investment in China.