Cost of Capital - Basics 1 / 7

Specimen
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MC Question 16

Par Co currently has the following long-term capital structure:

$m $m
Equity finance
Ordinary shares 30·0
Reserves 38·4
68·4
Non-current liabilities
Bank loans 15·0
8% convertible loan notes 40·0
5% redeemable preference shares 15·0
70·0
Total equity and liabilities
138·4

The 8% loan notes are convertible into eight ordinary shares per loan note in seven years’ time. If not converted, the loan notes can be redeemed on the same future date at their nominal value of $100. Par Co has a cost of debt of 9% per year.

The ordinary shares of Par Co have a nominal value of $1 per share. The current ex dividend share price of the company is $10·90 per share and share prices are expected to grow by 6% per year for the foreseeable future. The equity beta of Par Co is 1·2.

The loan notes are secured on non-current assets of Par Co and the bank loan is secured by a floating charge on the current assets of the company.

In terms of risk to the investor, what are the riskiest and least risky sources of finance for Par Co?

Riskiest Least risky
A.Redeemable preference shares Bank loan
B.Ordinary shares Bank loan
C.Bank loan Loan notes
D.Ordinary shares Loan notes
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Sample
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Question 4b

Dinla Co has the following capital structure.
Equity and reserves$000 $000
Ordinary shares23,000
Reserves247,000
270,000
Non-current liabilities
5% Preference shares5,000
6% Loan notes11,000
Bank loan3,000
19,000
289,000

The ordinary shares of Dinla Co are currently trading at $4·26 per share on an ex dividend basis and have a nominal value of $0·25 per share. Ordinary dividends are expected to grow in the future by 4% per year and a dividend of $0·25 per share has just been paid.

The 5% preference shares have an ex dividend market value of $0·56 per share and a nominal value of $1·00 per share. These shares are irredeemable.

The 6% loan notes of Dinla Co are currently trading at $95·45 per loan note on an ex interest basis and will be redeemed at their nominal value of $100 per loan note in five years’ time.

The bank loan has a fixed interest rate of 7% per year.

Dinla Co pays corporation tax at a rate of 25%.

Required:
(b) Discuss the connection between the relative costs of sources of finance and the creditor hierarchy. (3 marks)

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MC Question 15

Which of the following statements is/are correct?

1 An increase in the cost of equity leads to a fall in share price
2 Investors faced with increased risk will expect increased return as compensation
3 The cost of debt is usually lower than the cost of preference shares

A. 2 only
B. 1 and 3 only
C. 2 and 3 only
D. 1, 2 and 3

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