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Clements plc is just about to pay dividend of 14p per share to its shareholders. Over the past five years, it has increased its dividend by %5 per annum, on average. The company has 1 million ordinary shares in issue with a current market price of 1.26 pounds (cum-dividend). The company also has 1 million pounds of %10 irredeemable debentures with a nominal value of 100 pounds per debenture. These have a current market value of 115.50 pounds (ex-interest) per debenture. The debenture holders have just received their annual interest payment. You should assume that the company pays corporation tax at%30. A) Calculate the weighted average cost of capital for Clements plc using market values. b) Calculate what the cost of debt would have been in (a) above, if the debentures were redeemable at par in four years time, and price quoted above was 115.5o pounds (cum-interest) because the interest was just about to be paid to the debenture holders. c) Clements plc currently operates in the food retail sector but is considering acquiring a house building company. Should the bid succeed it will fund the acquisition with an issue of an additional 1 million pounds of %7 debentures. Provide a critical assessment as to ho suitable the weighted average cost of capital you calculated in (a) above, would be to use in the assessment of this investment.
Capital budgeting and the calculation of the WACC should be done for the business and the calculation of Cost of debt or IRR for the project to be undertaken. In a situation where Cost of debt is greater than the WACC, then it is not viable business project and it should be abandoned. It is prudent to note that, financial theory would recommend pursuing all projects that have an IRR in excess of WACC, but this should be done cautiously.In addition, increasing the debt of a company or selling more shares normally alters WACC since the expected return on debt and equity rise. In conclusion corporation financial management is pivotal in business management. In this regard, it is important that the decision making process is performed logically based on the capital budgeting analysis.