Brown limited is considering the financial viability of an investment project. The internal rate of return for the project is 13%. While this rate is higher than the market rate, the management would like to compare it to the company's current cost of capital. You have been provided with the following information and asked to calculate the weight average cost of capital.
The company issued 2,000 six year semi-annual bonds two years ago with a face value of $1,000 and coupon rate of 8%. The bonds are currently trading at $1150. The company also have a 9% term loan with an outstanding principal of $750,000. The only other component of debt is a $1.2 million 7.5% mortgage.
The company have three components of equity including;
Retained earnings of $800,000
Ordinary shares par value $3.00 $6 million
14% preference shares par value $5.00 $2 million
Additional Information:
The ordinary shares are currently trading at $4.25 while the Preference shares are trading at $5.50.
Return on government bonds is 4%, the market risk premium 7% and the growth rate in dividends has been consistently 3% over the past six years. A consultant has estimated the company to have a beta of 1.4.
Dividends paid per ordinary share last year was $0.75
Corporate tax rate is 35%
The bonds are currently trading for $1150 per bond
Interest on the term loan is 9% and the Mortgage 7.5%.
Calculate the weighted average cost of capital for Brown Limited using the market valuation approach. (In calculating the cost of ordinary shares you should use the average based on the dividend growth and capital asset pricing model (CAPM) - show your workings).