Question 3 A new finance intern at Texla Inc. has advised the board of directors to increase the company's capital gearing to 50%, to reduce its cost of capital and increase its market value. The managing director of Texla is not convinced by the logic of the proposal ,or the accuracy of the calculations ,but is unable to explain the reasons for his reservations A summary of the proposal and its implications is shown below. Proposal to increase the capital gearing of Texla Inc. The company's current weighted average cost of capital is estimated to be 11.75 %. If the proportion of debt is increased to 50% of total capital , by the repurchase of ordinary shares at their current market value ,the cost of capital may be reduced to 10.08%. A reduced cost of capital means that the value of the company will increase which will be welcomed by our shareholders .Calculations supporting the above proposal are shown below : Existing cost of capital Cost 01 equity using capital asset pricing model :5% + (11.5 % - 5%) 1.1 = 12.15 % Cost 01 debt : 8% Weighted average cost of capital : 12.15 % X $350m + 8% X $250m = 11.75 % $600m $600m Estimated new cost of capital 12.5 % X $250m + 8% X $250m = 10.08 % $500m $500m Impact on the value of the company Current value $100m = $851 million 0.1175 Expected new value $100m = $992 million 0.1008 Other information (a) The current price of Texla's ordinary shares is 410 cents. (b) The market price per $100 nominal value of 8% loan stock is $112. (c) The market return is 11.5 % and the risk free rate 5.0%