Question 4

Dynamic World Vista Industries (DWVI) wishes to estimate its cost of capital for use in analyzing projects that are similar to those that already exist. The firm's current capital structure, in terms of market value, includes 30 percent corporate bond, 10 percent irredeemable loan notes, 10 percent preference shares and 50 percent ordinary shares.

The firm's corporate bond has an average yield to maturity of 8.3 percent. DWVI also has an irredeemable loan notes currently trading at GHc 40 ex interest an interest rate of five (5) percent. Its preference shares have a Gllc 70 par value, an 8 percent dividend, and are currently selling for GHc 76 per share. DWVI's beta is 1.05, return on riskless asset is 4 percent and the return on the GSE (the market proxy) is 11.4 percent. The industry is in the 40 percent marginal tax bracket.

Required:

a) What are DWVI's pre-tax costs of debts, preference shares and ordinary shares?

b) Calculate DWVI's weighted average cost of capital (WACC) on both a pre-tax and after tax basis. Which W ACC should DWVI uses when making investment decisions and Why?

c) DWVI is contemplating a major investment that is expected to increase both its operating and financial leverage. Its new capital structure will contain 40 percent corporate bond, 10 percent irredeemable loan notes, 10 percent preference shares and 40 percent ordinary shares. As a result of the proposed investment, the firm's average yield to maturity on the corporate bond is expected to increase to 9 percent, the market value or selling price of the preference shares is expected to fall to their GHc 70 and its beta is expected to rise to 1.15. What effect will this investment have on SVI's after-tax WACC?

d) Explain the effect of the fall in selling price of the preference shares on the DWVI's W ACC