SAFOO Ltd has in issue 5 million shares with a market value of GH¢ 3.81 per share. The equity beta of the company is 1.2. The yield on short- term government debt is 23% per year and equity risk premium is 5% per year. The debt finance of SAFOO Ltd consists of bonds with a total book value of GH¢2 million. These bonds pay annual interest before tax of 25%. The par value and market value of each bond is GH¢100. The Company pays tax at 25%.
Required:
Calculate SAFOO Ltd Weighted Average cost of Capital. (10 marks)
View Solution
Cost of equity = 23 + (1.2 x 5) = 29%.
The company’s bonds are trading at par and therefore the before tax cost of debt is the same as the interest rate on the bonds which 25%.
After tax cost of debt = 25% x (1-0.25) = 18.75%.
Market value of equity = 5m x 3.81 = GH¢ 19.05 million
Market value of debt is equal to its par value of GH¢ 2 million.
Sum of Market value of equity and debt = 19.05 million + 2 million = GH¢ 21.05 million.
Weighted Average Cost of Capital (WACC) = (0.29 X 19.05/21.05) + (0.1875 X 2/21.05)
= (0.2900 X 0.905) + (0.1875 X 0.095)
= 0.2625+0.178
= 0.2803 or 28.03%