The ordinary shares are quoted at 80p. Assume that the market estimate of the next ordinary dividend is 4p, growing thereafter at 12% per annum indefinitely. The preference shares, which are irredeemable, are quoted at 72p and the debentures are quoted at par. Corporation tax is 35%.

(a) You are required to use the relevant data above to estimate the company’s weighted average cost of capital (WACC), i.e. the return required by the providers of the three types of capital, using the respective market values as weighting factors.

(b) You are required to explain how the Capital Asset Pricing Model would be used as an alternative method of estimating the cost of equity, indicating what information would be required and how it would be obtained.

(c) Assume that the debentures have recently been issued specifically to fund the company’s expansion programme under which a number of projects are being considered. It has been suggested at a project appraisal meeting that because these projects are to be financed by the debentures, the cut-off rate for project acceptance should be the after-tax interest rate on the debentures rather than the WACC.

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(d) Assume that instead of raising £5 million of 14% debentures, the company had raised the equivalent amount in preference shares giving the same yield as the existing preference capital.
You are required:
(i) to demonstrate that the returns offered to investors in the two securities are consistent with investor risk aversion; and (ii) to calculate how Leisure International plc’s equity earnings would have been affected if the preference shares had been issued instead of the loan capital.
Assume income tax of 25% where relevant.