Reference no: EM133139845

Question - Kapitale pic a multinational corporation operates in three industrial sectors. The company has a policy of paying out 60% of its earnings as dividends. It has a return on book equity of 20%! Its shares are quoted on the Official List of the London Stock Exchange at a price of £8 per share. There are 40 million shares in issue. Kapitale PIc has an equity beta of 1.15 and this may be taken as the appropriate adjustment to the risk premium of the average share over the risk-free rate of return. he average share has shown an extra return of 7.2% over the risk-free rate between 1946 and 2005. The current risk-free rate is 5%. The corporation tax rate is 31 %: A 10% coupon bond was issued at par value (£100) many years ago. In three years time the bond is to be redeemed at par. The coupons are paid annually ex-interest. The current market price of the bond is £98.25. The total par value of the bond is £50m.

Kapitale pc decides to diversity into a completely different business area and decides to look at betas of firms currently trading in the new business area. A review of various data sources reveals that the average beta of the industry Kapitale wants to expand Into Is 1.6 with an average debt to equity ratio of 33%.

You recall that the relationship between geared and ungeared beta can be represented by the equation below.

Pgeared = Bungeared!1+ (1-t)D/E]

Required -

(a) Calculate the current after-tax cost of the bond and the cost of current equity.

(b) Calculate the current weighted average cost of capital.

(c) What discount rate should the company use to evaluate the viability of the new business if the company considers its current capital structure to be optimal? Show relevant calculations.

(d) Explain the significance of the cost of capital in helping managers to achieve the objective of shareholder wealth maximisation.