QUESTION 14

Dangerfield Ltd (Dangerfield) is considering the purchase of new equipment for its manufacturing plant, and has asked you to work out an appropriate discount rate to use when evaluating the project. While working out the appropriate discount rate, you make the assumption that Dangerfields present capital structure represents the optimal mix of capital sources for the firm.

Your information about Dangerfields present capital structure is as follows:

Source of capital		Market value
Debt		$2,650,000
Preference share capital		$350,000
Ordinary share capital		$4,000,000
Total		$7,000,000

To finance the purchase, Dangerfield can sell 10 year bonds paying annual coupon interest at a rate of 7% at a market price of $1,020. Assume a tax rate of 30%.

Cumulative preference shares paying a dividend of $2.40 annually can be sold for $20 each.

Ordinary shares for Dangerfield are currently selling at $50. The company recently paid a dividend of $2.00 and dividends are expected to grow by an average of 6% per year for the indefinite future.

Required

1. Calculate the capital structure for each source of capital for Dangerfield.

[2 marks]

2. What is the after-tax cost for each source of capital (i.e. debt, preference share and ordinary share)?

[6 marks]

3. Assuming that the appropriate discount rate for the project is the firms weighted average cost of capital. Determine the discount rate to be used for evaluating the project considered by Dangerfield.

[2 marks]