The annual report of Matrix Corporation discloses the following information about the company. It has 21.6 million ordinary shares on issue, ordinary issued capital of £43.2 million and retained profit of £18.5 million. The company pays dividends annually and the most recent dividend was 25 pence per share. Its debt consists of 80,000 15% bonds, maturing in 3 years’ time; each bond has a face value of £100. It also has 150,000 preference shares (or preferred stock) on issue, each with a face value of £50, and paying a fixed dividend rate of 12% per year.

The current market price of the ordinary shares is £1.36 per share. The current market yield on the bonds is 8.55% per year. The current market price of the preference shares is £42.50 per share. Dividends are estimated to grow at 3.5% per year indefinitely.

1. Calculate Matrix Corporation’s weighted average cost of capital. Show all calculations.

2. You show your calculations to a colleague, who argues that the dividend growth model is an unreliable way of estimating the cost of equity capital. She suggests you should use the capital asset pricing model. You take her advice, and you estimate Matrix Corporation’s beta to be 1.5, the risk-free rate to be 4% and the expected return on the market portfolio to be 13%. Calculate your new estimate of WACC.

 

3. In what circumstances is it appropriate for Matrix Corporation to use the WACC determined in part (i) as the "hurdle rate" in project evaluation? Limit your answer to no more than 50 words.

1

WACC = Cost of Equity Capital * Share of Equity Capital + Cost of Preference Capital * Share of Preference Capital + Cost of Debt (bond) * Share of Debt (bond)

• Total Capital = Equity Share Capital + Preference Share Capital + Debt
= (43200000 +150000*50 + 80000*100) pounds     = (43200000 + 7500000 + 8000000) pounds
= 58700000 pounds

• • Share of Respective Capitals
-> Equity = 43200000/58700000 = 73.60%
-> Preference = 7500000/58700000 = 12.7%
-> Debt = 8000000/58700000 = 13.7%

Assuming Tax-Rate is NiL

• Cost of preference share capital = Dividend rate of preference share
= 12%
[It is assumed that the will be having sufficient earnings to pay the dividend]

• Cost of equity capital (using Gordon's growth model)
= [Dividend * (1 + growth rate) / price ] + growth rate
= [0.25 * (1 + 3.5%) / 1.36] + 3.5%
= 19.025% + 3.5%
= 22.525%

• Cost of Debt
= Interest rate on Debt
= 15%


So, applying all the values in the WACC formula, we get;

WACC = 73.60%*22.525% + 12.7%*12% + 13.7%*15%
= 16.5784% + 1.524% + 2.055%
= 20.1574%

2

Cost of equity using CAPM = Risk-free rate + Beta * (Market Return - Risk-free return)
= 4% + 1.5 * (13% - 4%)
= 4% + 1.5 * 9%
= 4% + 13.5%
= 17.5%

WACC (with cost of equity being 17.5%)
= 73.60%*17.5% + 12.7%*12% + 13.7%*15%
= 12.88% + 1.524% + 2.055%
= 16.459%

3

Gordon's growth model is based on one critical assumption that the firm regularly pays dividends to its shareholders and the rate at which the dividend amount grows remains constant, indefinitely. It values the WACC of the firm by taking into account the market price, thus making it more realistic.
So in case, the firm has been regularly paying dividends, dividends have been growing at a constant rate and it is believed that the share is fairly values then gordo's growth model can be used.