QUESTION 5

The finance director of XYZ Co has heard that the market value of the company will increase if the weighted average cost of capital of the company is decreased. The company, which is listed on a stock exchange, has 100 million shares in issue and the current ordinary share price is K2.50 per share. XYZ Co also has in issue bonds with

a book value of K60 million and their current market price is K104 per K100 bond. The current after-tax cost of debt of XYZ Co is 7% and the tax rate is 30%. The recent dividend per share of the company was K0.22 and dividends have been growing at (ngwee) 19.38, 20.20, 20.41, 21.02, 21.80

The finance director proposes to decrease the weighted average cost of capital of XYZ Co, and hence increase its market value, by issuing K40 million of bonds at their par value of K100 per bond. These bonds would pay annual interest of 8% before tax and would be redeemed at a 5% premium to par after 10 years.

Required:

1. Calculate the market value after-tax weighted average cost of capital of XYZ Co in the following circumstances:

1. before the new issue of bonds takes place;
2. after the new issue of bonds takes place.

Comment on your findings. (12 marks)

2. Discuss the directors view that issuing traded bonds will decrease the weighted average cost of capital of XYZ Co and thereby increase the market value of the company. State the capital structure theory(s) you are assuming in your discussion. (13 marks)

(Total = 25 marks)