Celtor plc is a property development business operating in the London area. The business has the following capital structure as at 30 November Year 9:

The ordinary shares have a current market value of £3.90 and the current level of dividend is 20p per share. The dividend has been growing at a compound rate of 4 per cent a year in recent years. The loan notes of the business are irredeemable and have a current market value of £80 per £100 nominal. Interest due on the loan notes at the year end has recently been paid.

The business has obtained planning permission to build a new office block in a redevelopment area. The business wishes to raise the whole of the finance necessary for the project by the issue of more irredeemable 9 per cent loan notes at £80 per £100 nominal. This is in line with a target capital structure set by the business where the amount of loan capital will increase to 70 per cent of ordinary share capital within the next two years. The tax rate is 25 per cent.

Required:

(a) Explain what is meant by the term ‘cost of capital’. Why is it important for a business to calculate its cost of capital with care?

(b) Calculate the weighted average cost of capital of Celtor plc that should be used for future investment decisions.

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£1 ordinary shares Retained earnings 9% loan notes £000 10,000 20,000 12,000 42,000