Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
A Company wants to seek additional source of external financing. The current book value
structure of the company is as follows:
GHS
13% Debentures (GHS 100 per debenture)
800,000
14% Preference Shares (GHS 100 per share)
200,000
Equity Shares (GHS 10 per share)
1,000,000
The following external financing opportunities are:
(i)
A debenture with 10-year maturity, 4% flotation cost and current market price of GHS
100.
(ii)
A redeemable
market price of GHS 100.
(iii)
Equity shares – GHS 2 per share flotation costs and current market price of GHS 22.
Dividend expected on equity share at the end year is GHS 2 per share, anticipated growth rate in
dividends is 7%. Company pays all its earnings in the form dividends. Corporate tax rate is 50%.
Required – Calculate the WACC
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