QUESTION 3

The following is an extract from the balance sheet of Leisure International plc at 30 June 2019:

000

Ordinary shares of 50p each 5,200

Reserves 4,850

9% preference shares of 1 each 4,500

14% debentures 5,000

Total long-term funds 19,550

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

(A) You are required to use the relevant data above to estimate the companys weighted average cost of capital (WACC), that is the return required by the providers of the three types of capital, using the respective market values as weighting factors. (5 marks)

(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. (5 marks)

(C) Assume that the debentures have recently been issued specifically to fund the companys 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 rate on the debentures rather than the WACC.

You are required to comment on this suggestion. (5 marks)

(D) Assume that instead of raising 5 m 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: (10 marks)

To demonstrate that the returns offered to investors in the two financial instruments are consistent with investor risk aversion;

To calculate how Leisure International plcs equity earnings would have been affected if the preference shares had been issued instead of the debentures.