The finance director of Kingsize plc is currently reviewing the capital structure of her company. She is convinced that the company is not financing itself in a way that minimises its cost of capital (WACC). The companys financing as at 1 January 20X8 is as follows:

000 Ordinary shares, 1 each 15,000

Reserves 10,000

7% preference shares, 1 each 10,000

10% bonds (redeemable after 7 years) 15,000

50,000

Other information (as at 1 January 20X8):

Ordinary share price (ex-div) 2.65

Preference share price (ex-div) 75p

Bond price for 10% bonds 102

Last 5 years dividends (most recent last) 22p, 23p, 25p, 27p, 29p

The finance director feels that by issuing more debt the company will be able to reduce its cost of capital. She proposes the issue of 15m of 11 per cent bonds. These bonds will be sold at a 5 per cent premium to their par value and will mature after seven years. The funds raised will be used to repurchase ordinary shares which the company will then cancel. She expects the repurchase will cause the companys share price to rise to 2.78 and the future dividend growth rate to increase by 20 per cent (in relative terms). She expects the price of the 10 per cent bonds to be unaffected, but the price of the preference shares to fall to 68p. Corporate tax stands at 30 per cent.

a. Calculate the current cost of capital (WACC) for Kingsize plc.

b. Given the proposed changes to Kingsizes capital structure, recalculate the companys cost of capital to reflect these changes and comment on the finance directors projections.

c. Identify and discuss possible inaccuracies that may occur with the finance directors estimates.