Web plc operates a low-cost airline. It has expanded in recent years. The shares (equity) of the company are mainly held by large financial institutions. The following extracts from Web plc’s budgeted balance sheet at 31st May 2002 give a snap shot of the capital budget of the company.
Ordinary shares (Number of shares = 100 million) 100 $ million value at issue.
Reserves 50 $ million
9% Debentures (i.e., unsecured corporate bonds) 200 $ million
A dividend of $1 per share is expected to be declared on 31st May 2002 (assume that the dividend will also be paid on this date). Due to expansion dividends are expected to grow at 4% per year for the foreseeable future (i.e., beginning on 1st June 2002). In the secondary market the shares currently trade at a price of $10.4 dollars (i.e., on the 31st May ex-div).
Existing corporate bonds are due to be redeemed at the issue value of $200mil on 31st May 2005 (i.e., 3 years to redemption). On 1st June 2002 the market value of a $100 nominal bond is $100.84. The interest on this debt is paid in advance of corporation tax (which is 30%).
The company now wants to purchase 3 ne aircraft at a cost of $10million each. The board wants to finance this with bank borrowing at 8% which will be drawn down on 1st June 2002.
(a) Calculate the expected weighted average cost of capital of Web plc at 31st May 2002.
(b) Without further calculations, explain the likely impact of the new bank loan on Web plc’s
i. Cost of equity
ii. Cost of debt
iii. Weighted average cost of capita
(c) Suggest possible reasons why the cost of bank borrowing differs from the cost of debenture financing in the case of this company.