Cheadle Ltd and Heath Ltd are both public companies whose shares are quoted on the Stock Exchange. Both earn an annual profit, before charging debenture interest, of £3 million, and it is generally expected that they will continue to do so indefinitely. The profits of both companies, before charging debenture interest, are generally regarded as being subject to an identical degree of risk.
Cheadle Ltd is financed entirely by 7.5 million ordinary shares, which have a market value of £2 each. Heath Ltd has issued £15 million undated 6% debenture stock which have a current market yield of 12%. The ordinary share capital of Heath Ltd comprises 3 million ordinary shares whose market value is £2.80 each. It is the policy of both companies to distribute all available profits as dividends at the end of each year.
Mr Rice owns 30,000 ordinary shares in Heath Ltd, and is wondering whether he could increase his annual income, without incurring any extra risk, by selling his shares in Heath Ltd and buying some of the ordinary shares of Cheadle Ltd. If necessary, he can borrow money from his bank at an annual interest cost of 12%.
(a) Calculate the cost of ordinary share capital and the weighted average cost of capital (WACC) for each company. Explain why both the cost of ordinary share capital and the WACC of Cheadle Ltd differ from those of Heath Ltd. (Ignore Taxation)
(b) Provide some advice to Mr Rice on whether he can improve his position in the way he has suggested. State clearly any reservations you have about the scheme. What would happen if other shareholders act in a similar manner to Mr Rice?