QUESTION TWO You are employed in a firm of financial analysts and you are part of the team that is involved in assisting client companies to calculate their costs of capital RST Plc and PQR Plc are two of client companies of your firm. The two companies have provided the following information: RST Pic POR Pic K million K million Share capital (ordinary shares of K1.00 each) 250 380 Retained earnings 700 420 9% Preference Shares 200 180 12% Bond 500 500 The market price of each ordinary share of RST Plc is K4.90 while the ordinary shares of POR Plc have a market price of K5.45. The market price of Preference shares for each company is KO 80 The 12% Bond of RST Plc has a total market value of K525 million while the 12% Bond of POR Plc has a total market value of K495 million RST Plc has just paid an annual dividend of K0.50 per share. Dividends have grown annually at an average rate of 5% and it is expected that this growth rate will continue for the foreseeable future. POR Plc has just paid its annual dividend of K0,60 per share. For PQR Pic, dividends are expected to grow at an average annual growth rate of 3.75% Both companies pay tax on their profits at the rate of 35%. The after tax cost of the bonds is 9% for RST Plc and 7.85% for PQR Plc. You have also established that the risk free rate of return is 7.48% and the market risk premium is 5.76%. The relevant beta factors are 1.5 for RST Plc and 1.8 for POR Ple. Required: (a) Calculate the cost of equity for RST Plc and for POR Ple using (1) The dividend growth model [4 Marks) (1) The capital asset pricing model [4 marks) (b) Calculate the following for each of the two companies Cost of preference shares [4 Marks) After tax weighted average cost of capital using the cost of equity calculated using the capital asset pricing model. [8 Marks] (c) Explain the problems which would be faced by a company that fails to calculate its cost of capital [5 Marks)