Assignment instructions:
The CFO of ABC plc is analyzing the capital structure of the organization. He claims that ABC is not financing itself in a way which reduces its cost of capital (WACC). The information below represents ABC's financing as at 31 December 2016:
£000
Ordinary shares, £1 each
20,000
Reserves
5,000
7% preference shares, £1 each
10,000
10% bonds (irredeemable 31 December 2016)
15,000
Total capital
50,000
Other information from the stock market (as at 31 December 2016):
Ordinary share price (ex-div) £2.65
Preference share price (ex-div) 75p
Bond price for 10% bonds £107 per £100
Last 5 years' dividends (most recent last) 21p, 23p, 25p, 27p, 28p
The CFO states that by issuing more debt, ABC will lower its cost of capital. He suggests issuing £15m of 11 percent bonds. These bonds will be sold at a 5 percent premium to their par value and will mature after 7 years. The money will be used to repurchase ordinary shares, which ABC will further cancel. The CFO presumes that repurchasing will result in the organization's share price rising to £2.85 and the future dividend growth rate to grow by 20 percent (relatively). He anticipates the price of the 10 percent bonds to be unaffected, but the price of the preference shares to drop to 68p. Corporate tax stands at 30 percent.
You are required to:
1) Calculate the book value and market value cost of capital (WACC) for ABC plc. (35 marks)
2) Considering the proposed changes to ABC's capital structure, recalculate the organization's cost of capital to reflect these changes and comment on the CFO's forecasts. (35 marks)
3) Critically analyze whether you consider that organizations, by integrating a sensible level of gearing into their capital structure, can decrease their WACC, ensuring the response integrates relevant empirical research within this area of study. (30 marks)