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- 5 Marks
Question
Paisley Brothers Ltd, a company producing loud paisley shirts, has a net operating income of GH¢20,000 and is faced with the following three options for how to structure its debt and equity:
i) Take no debt and pay shareholders a return of 9%.
ii) Borrow GH¢50,000 at 3% and pay shareholders an increased return of 10%.
iii) Borrow GH¢90,000 at 6% and pay a 13% return to shareholders.
Assuming no taxation and a 100% payout ratio:
Required:
Calculate the Weighted Average Cost of Capital (WACC) for each of the options and determine which method is optimal. (5 marks)
Answer
i) Option 1 (No Debt):
Income of GH¢20,000 is distributed to shareholders who require a return of 9%.
- Market value of equity = GH¢20,000 / 0.09 = GH¢222,222
- WACC = 9%
ii) Option 2 (GH¢50,000 Debt at 3%):
Interest on debt = GH¢50,000 × 3% = GH¢1,500
Dividends to shareholders = GH¢20,000 – GH¢1,500 = GH¢18,500
- Required return of shareholders = 10%
- Market value of equity = GH¢18,500 / 0.10 = GH¢185,000
- Market value of debt = GH¢50,000
- Total value of the company = GH¢185,000 + GH¢50,000 = GH¢235,000
- WACC = (10% × GH¢185,000 + 3% × GH¢50,000) / GH¢235,000
= (18,500 + 1,500) / 235,000
= 8.51%
iii) Option 3 (GH¢90,000 Debt at 6%):
Interest on debt = GH¢90,000 × 6% = GH¢5,400
Dividends to shareholders = GH¢20,000 – GH¢5,400 = GH¢14,600
- Required return of shareholders = 13%
- Market value of equity = GH¢14,600 / 0.13 = GH¢112,308
- Market value of debt = GH¢90,000
- Total value of the company = GH¢112,308 + GH¢90,000 = GH¢202,308
- WACC = (13% × GH¢112,308 + 6% × GH¢90,000) / GH¢202,308
= (14,600 + 5,400) / 202,308
= 9.9%
Conclusion:
The optimal capital structure is the one with the lowest WACC and highest market value. In this case, Option 2 is the optimal choice, with the lowest WACC of 8.51% and a total company value of GH¢235,000.
- Tags: Debt Financing, Equity Financing, Optimal Capital Structure, WACC
- Level: Level 3
- Topic: Theories of capital structure
- Series: MAY 2018
- Uploader: Theophilus