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solution

Innovation Company has the following capital structure.
$’m
$’m
Equity
Reserves
23
Ordinary shares
247
270
Non-current liabilities
5% preference shares
5
6% loan notes
11
Bank loan
3
19
289
The ordinary shares of Innovation Company are currently trading at $4.26 per share on an ex-dividend basis and have a nominal value of $0.25 per share, Ordinary dividends are expected to grow in the future by 4% per year and a dividend of $0.25 per share has just been paid.
The 5% preference shares have an ex-dividend market value of $0.56 per share and a nominal value of $1.00 per share. These shares are irredeemable.
The 6% loan notes of Innovation Company are currently trading at $95.45 per loan note on an ex- interest basis and will be redeemed at their nominal value of $100 per loan note in 5 years time.
The bank loan has a fixed interest rate of 7% per year.
Innovation Company pays corporation tax at a rate of 25%
Required
(a)Calculate the after-tax weighted average cost of capital of Innovation Company on a market value basis.
(b)Explain why we use market value weights in the weighted average cost of capital (WACC)?
(c)Discuss why the cost of equity is greater than the cost of debt.

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