Page 31 - MCS August Day 1 Suggested Solutions

SUGGESTED SOLUTIONS

priced at a discount to the market price it may not raise as much finance in comparison to an
issue of shares at market value.

Montel could consider creating and issuing alternative classes of shares such as preference
shares. However, it would need to be careful as to whether the preference shares would meet the
definition of a financial liability (debt) or not. If the preference shares were redeemable or carried
an obligation to pay a dividend, they would have to be classed as debt finance. The related
dividends would be recognised as finance costs and charged against profit as an expense. This in
turn would have the impact of increasing the gearing ratio and reducing interest cover.

Creating an additional class of shares would be beneficial to Montel if it wanted to be able to be
pay different levels of dividend to new shareholders compared to current equity shareholders.

Compound instruments

A further option would be to issue a compound financial instrument, such as a convertible bond.
This would enable Montel to raise finance at a lower cost compared to simple debt finance. Since
convertible bonds will be recorded partly as debt and partly as equity they would also have a less
adverse effect on the gearing ratio compared to regular bonds.

Investors may consider convertible bonds to be a less risky way of investing in Montel and may be
attracted by the potential of becoming an equity shareholder at some future date with the
potential to receive dividends.

Calculation of WACC

Cost of debt
Effective interest rate (per exercise 1) is 10.0% in 2018 also 2017.

Effective tax rate is 17% (to nearest %) in 2018 and also 2017.

For both years, the post‐tax cost of debt is therefore in the region of 8.3% (10.0% x (1‐ 0.17))
assuming that debt is long‐dated or irredeemable.

Cost of equity
It is not possible to calculate the cost of equity as the share price of Montel is not provided.

WACC

A weighted average cost of capital would be calculated by taking an average of the cost of debt
and the cost of equity, using the market values of the debt and equity finance as the relative
weightings.

As the cost of equity cannot be calculated from the available information, it is not possible to
calculate WACC. Accurate calculation of this is important for investment appraisal decisions.

However, it is only appropriate to use WACC when the following conditions are met:

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