QUESTION 3 - 25 MARKS

WEIGHTED AVERAGE COST OF CAPITAL (WACC)

Pure Step operates as a gym in South Africa and is currently listed on the Johannesburg Stock Exchange. Pure Step was established 10 years ago and is classified as a high growth business with the ability to play into this Get Healthy trend that the country is experiencing. The two founders of the business have asked that you assist in determining the discount rate that can be used to evaluate any new projects. The following information has been obtained which might be useful in estimating the weighted average cost of capital i.e., the discount rate.

Equity capital

Pure Step currently has 5 million shares outstanding, and the current share price is R50.

The beta is estimated to be 1.25 with the market risk premium of 12% and a risk-free rate of 8%.

Preference share capital

In anticipation of the investment into high tech and modern gym equipment, Pure Step issued 900 000 convertible preference shares with a par value of R125 per share on 31 December 2019. Transaction costs incurred were considered negligible. The preference shares pay annual dividends at a dividend rate equivalent to 80% of the prevailing prime interest rate (as at the end of each financial period). Other listed preference shares with a similar risk profile and maturity are trading at the prime interest rate plus 3% at 31 December 2022.

Debt capital

On 31 December 2020, Pure Step borrowed R300 million in the form of a loan from Partner Bank Ltd. The loan is repayable with annual instalments payable on 31 December each year until 31 December 2025 with a final lump sum payment of R100 million on the 31st of December 2025. The loan bears interest at a fixed rate of 10,75% per annum. On the 31 December 2022, the market related interest rate on similar instruments was estimated at the prime interest rate.

ADDITIONAL INFORMATION

The corporate income tax rate is 28% and prime interest rate is 10,25% per annum.

Pure Step targets a debt-to-equity ratio of a third with the equity being split equally among preference shares and ordinary shares.

REQUIRED

(a) Determine the weighted average cost of capital of Pure Step. 15 marks

(b) Is it more advantageous for Pure Step to issue debt or equity with the additional funding requirements? Discuss and comment on how a companys capital structure impacts the weighted average cost of capital. 10 marks