Riphean plc and Silurian plc are two businesses operating in different industries from one another. They are both financed by a mixture of ordinary share and loan capital and both are seeking to derive the cost of capital for investment decision making purposes. The following information is available concerning the two businesses for the year to 30 November Year 8:

Riphean Silurian plc plc Profit for the year £3.0m £4.0m Gross dividends £1.5m £2.0m Market value per ordinary share £4.00 £1.60 Number of ordinary shares 5m 10m Gross interest yield on loan capital 8% 12%

Market value of loan capital £10m £16m The annual growth rate in dividends is 5 per cent for Riphean plc and 8 per cent for Silurian plc.

Assume a 30 per cent tax rate.

Required:

(a) Explain what is meant by the term ‘cost of capital’ and state why it is important for a business to calculate its cost of capital correctly.

(b) Calculate the weighted average cost of capital of Riphean plc and Silurian plc using the information provided.

(c) Discuss two possible reasons why the cost of ordinary share capital differs between the two businesses.

(d) Discuss two limitations of using the weighted average cost of capital when making investment decisions.