My—pattern Investments Ltd is considering the investment in a new project to produce a wide range of colourful chocolates. This project will be the largest the company has ever attempted. According to initial estimations the project will require an initial investment of N$14 million. The project involves the development of a manufacturing plant on the Western Cape coast. Although management understands the principles of cost of capital, they don’t know exactly how to calculate the rate. My-pattern Investments Ltd’s management approached you for advice, since you are regarded as an expert in this field. You are provided with the following information:
Extracts from the Profit & Loss Statement for the year end
The company recently had a rights issue of 40 000 shares at a premium. All previous share issues were at N$3 per share. The rights issue was at a 10% discount to market value, which had resulted in the current market price per share of N$10.28. Eight months ago My-pattern lnvestments’ beta was calculated at 1.2. According to market indicators the return in the food sector is 21%. The return on the market as a whole however is 19.4%. Current capital market rates are:
Government bond -14.7%
The return on similar preference share is 13%. The shares are partly (40%) redeemable in 4
years and the balance in 8 years. Redemption will be at a premium of 10%.
According to the loan holder the loan can be redeemed at N51 650 000. The loan contract is
for a 10 year period.
The debentures are non-interest bearing instruments. According to the debenture deed the
debentures will be redeemable in 9 years’ time. These debentures are currently trading at
N$6.50 each. According to analysts the market requires 15% on similar investments.
You may assume the following:
0 That the market does not to know about the project.
0 Tax rate is 28%
0 Food Inflation rate is 9.8%
a) Determine the Weighted Average Cost of Capital for the project (25 marks)
b) Briefly explain what effect the choice of a financing source should have on the cost of
capital (3 marks)
c) Explain the effect of the past few months’ market fluctuations (exchange rates,
interest rates, etc.) on a companies’ cost of capital in general