Petalt plc wishes to carry out a shareholder value analysis for which it has gathered the information shown in the table below:
The managers do not yet know the cost of capital but do have the following information. The capital is in three forms:
1. A floating-rate bank loan for £1 m at 2 per cent over bank base rate. Base rates are currently 9 per cent.
2. A 25-year vanilla bond issued 20 years ago at par (£100) raising £lm. The bond has an annual coupon of 5 per cent and is currently trading at £80. The next coupon is due in one year.
3. Equity capital with a market value of £2m.
Latest annual sales £lm
Sales growth rate .............................................. 10%
Operating profit margin before tax ......................... 10%
Tax rate on corporate profits ................................. 31%
Incremental fixed capital investment ....................... 17% of sales change
Incremental working capital investment ................... 6% of sales change
Planning horizon .............................................. 5 years
The rate of return available by purchasing long-term government securities is currently 6 per cent and the average risk premium for shares over the risk-free rate has averaged 5 per cent. Petalt's shares have an above-average risk and its historic beta as measured by the co-movement of its shares and the market index correctly reflects the risk adjustment necessary to the average risk premium - this is 1.3.
Required
a. Calculate the cost of bond finance.
b. Calculate the cost of equity finance.
c. Calculate the weighted average cost of capital.
d. Calculate shareholder value using Rappaport's method.
e. Conduct sensitivity analysis on the calculated shareholder value by altering the operating profit margin and the number of years in the planning horizon. Show a table containing alternative profit margin assumptions and planning horizon assumptions.