The finance director of AQR Co has heard that the market value of the company will increase if the weighted average cost of capital of the company is decreased. The company, which is listed on a stock exchange, has 100 million shares in issue and the current ex div ordinary share price is $2·50 per share. AQR Co also has in issue bonds with a book value of $60 million and their current ex interest market price is $104 per $100 bond. The current after-tax cost of debt of AQR Co is 7% and the tax rate is 30%.
The recent dividends per share of the company are as follows.
The finance director proposes to decrease the weighted average cost of capital of AQR Co, and hence increase its market value, by issuing $40 million of bonds at their par value of $100 per bond. These bonds would pay annual interest of 8% before tax and would be redeemed at a 5% premium to par after 10 years.
Required:
(a) Calculate the market value after-tax weighted average cost of capital of AQR Co in the following circumstances:
(i) before the new issue of bonds takes place;
(ii) after the new issue of bonds takes place. Comment on your findings. (12 marks)
(b) Identify and discuss briefly the factors that influence the market value of traded bonds. (5 marks)
(c) Discuss the director’s view that issuing traded bonds will decrease the weighted average cost of capital of AQR Co and thereby increase the market value of the company. (8 marks)