African Oxygen Limited (Afrox) is sub-Saharan Africa’s market leader in gases and welding products. Afrox was founded in 1927, listed on the JSE in 1963, and has prospered by constantly meeting the needs of customers and developing solutions that add value to customers’ applications. Afrox operates in South Africa and in 10 other African countries and manages operations in five more on behalf of their parent company, The Linde Group, a global gases, engineering and technology company. Their processes include blanketing, purging and sparging.
To ensure safe and efficient cost effective sparging, Afrox Ltd has proposed to acquire a new reactor that uses dry gas, that is, gaseous liquid nitrogen (GLN). The new reactor will cost N$4 500 000 and will guarantee annual cost savings of N$3 600 000. The incremental costs are N$2 300 000 per annum and the new reactor is estimated to have a life span of 5 years.
The capital structure of Afrox Ltd include the following:
- 600 000 N$2 ordinary shares currently trading at N$2.40 per share.
- 200 000 preference shares trading at N$2.50 per share (issued at N$3 per share). 10 % p.a. fixed rate of interest.
- A bank loan of N$1 000 000 at 12 % p.a. (payable in five years’ time)
- The company’s beta is 1,4. A return on market of 15% and a risk-free rate of 6%.
- Current tax rate is 28 %.
- Current dividend is 50c per share and dividends are expected to grow by 7 % per annum, forever.
a) Calculate the cost of Afrox’s equity using:
i. Capital Asset Pricing Model (CAPM)
ii. Dividend Discount Model (DDM)
b) Calculate the cost of preference shares and the after-tax cost of debt
c) Calculate the Weighted Average Cost of Capital (WACC) of Afrox Ltd using CAPM for cost of equity
d) Assuming a WACC of 14%, and using relevant calculations, advise whether Afrox should acquire the new reactor
e) Suppose Afrox Ltd would like to finance other new projects and can only make use of one of the sources of finance (equity, preference shares or debt), which of the three would you recommend? Justify your answer