SECTION B (Answer all parts of the question) 4. Sugar plc and Tea plc are two similar companies that operate in the same line of business. Both companies distribute all their earnings as dividends. Tea plc No of ordinary shares in issue 10 million Share price 400p Earnings before interest and tax 18 million Sugar plc 35 million 350p 60 million Tea also has in issue 30 million 5% irredeemable debentures with a current market value of 57.50 each. Sugar plc has in issue 80 million 10% irredeemable debentures with a current market value of 115 each. The rate of corporation tax is given as 30%. Required (a) (0) Calculate for both Sugar plc and Tea plc the after tax cost of equity, the cost of debt, and the overall weighted average cost of capital plc. (24 marks) (ii) Mr Coffee is a shareholder in Sugar plc currently holding 1,000 shares. He is thinking of switching his investment from Sugar plc to Tea plc though wants to ensure that he retains the same level of risk. Carefully and fully explain to Mr Coffee, showing all calculations, what actions he would have to take if he wishes to go ahead with such a switch. Advise Mr Coffee whether such a switch would be worthwhile. (24 marks) (iii) Calculate Mr Coffee's original income in Sugar plc and also his new income in Tea plc. assuming he were to switch his investment in the way you have advised in part (ii). (14 marks) (iv) Given you answer in part (iii), what does this tell us about his new investment? Fully explain your answer (8 marks) (b) For the weighted average cost of capital to be a valid method to use for investment appraisal by companies there are a number of conditions which must hold. Discuss. (30 marks) 5. SECTION B (Answer all parts of the question) 4. Sugar plc and Tea plc are two similar companies that operate in the same line of business. Both companies distribute all their earnings as dividends. Tea plc No of ordinary shares in issue 10 million Share price 400p Earnings before interest and tax 18 million Sugar plc 35 million 350p 60 million Tea also has in issue 30 million 5% irredeemable debentures with a current market value of 57.50 each. Sugar plc has in issue 80 million 10% irredeemable debentures with a current market value of 115 each. The rate of corporation tax is given as 30%. Required (a) (0) Calculate for both Sugar plc and Tea plc the after tax cost of equity, the cost of debt, and the overall weighted average cost of capital plc. (24 marks) (ii) Mr Coffee is a shareholder in Sugar plc currently holding 1,000 shares. He is thinking of switching his investment from Sugar plc to Tea plc though wants to ensure that he retains the same level of risk. Carefully and fully explain to Mr Coffee, showing all calculations, what actions he would have to take if he wishes to go ahead with such a switch. Advise Mr Coffee whether such a switch would be worthwhile. (24 marks) (iii) Calculate Mr Coffee's original income in Sugar plc and also his new income in Tea plc. assuming he were to switch his investment in the way you have advised in part (ii). (14 marks) (iv) Given you answer in part (iii), what does this tell us about his new investment? Fully explain your answer (8 marks) (b) For the weighted average cost of capital to be a valid method to use for investment appraisal by companies there are a number of conditions which must hold. Discuss. (30 marks) 5
