FMF9
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Section C: Q36

Specimen exam

Q36 Section C

This scenario relates to three requirements.

Froste Co has a dividend payout ratio of 40% and has maintained this payout ratio for several years. The current dividend per share of the company is $0.50 per share and it expects that its next dividend per share, payable in one year's time, will be $0.52 per share.

The capital structure of the company is as follows:

  $m $m
Equity
Ordinary shares (nominal value $1 per share) 25
Reserves 35
60
Debt
Bond A (nominal value $100) 20
Bond B (nominal value $100) 10
30
90

Bond A will be redeemed at nominal value in ten years' time and pays annual interest of 9%. The cost of debt of this bond is 9·83% per year.

The current ex interest market price of the bond is $95·08. Bond B will be redeemed at nominal value in four years' time and pays annual interest of 8%. The cost of debt of this bond is 7·82% per year.

The current ex interest market price of the bond is $102·01. Froste Co has a cost of equity of 12·4%. Ignore taxation.

(c) Explain why Froste Co's capital instruments have different levels of risk and return.(5 marks)
(20 marks)