Financial Management Topic 6 : COST OF CAPITAL 

QUESTION 1

Nice Ltd. is considering raising capital from an issue of ordinary shares and debentures in a mix that will maintain its gearing ratio constant.

The company has an issued share capital of ten million ordinary shares of Sh. 100 par value. It has also issued Sh.800 million of 8% debentures.

 

The current market value of the ordinary shares is Sh.476 and that of each debenture (Sh.100 par) is Sh.77. Dividends and interest are payable annually. An ordinary dividend has just been paid. The next instalment of interest is payable in the near future. Debentures are redeemable at par in 15 years’ time.

 

An extract from the most recent statement of financial position is as follows

Sh. “million”   Sh. “million” Sh. “million”
Ordinary share capital

Reserves

Deferred tax

8% debentures

1,000

1,553

164

800

3,517

Non-current assets

Current assets Less: current

liabilities

 

 

4,166

(1,925)

1,276

 

2,241

____

3,517

 

Dividends and earnings have been as follows:

 

Dividends Sh. “million” Earnings before tax Sh. “million” Earnings after tax Sh. “million”
2009

2010

2011

2012

2013

200

230

230

260

300

575

723

682

853

906

350

452

410

536

606

 

The tax rate is 30%

 

Required:

Nice Ltd’s weighted average cost of capital (WACC).

December 2014 Question Four B

 

QUESTION 2

The following is the capital structure of Ngana Ltd:

  

  Sh. 
Ordinary share capital (par Sh.100)

Preference share capital (par Sh. 100)

Debentures (par Sh. 100)

80,000,000

35,000,000  27,000,000

 

Additional information: 

  • The shareholders of Ngana Ltd. expect earnings and dividends to grow at a constant rate of 5% in the future. The company has just paid a dividend of Sh4.00 per share.
  • The current market price of one ordinary share of Ngana Ltd. is Sh.80.
  • Treasury bonds yield 12%. The return on the market is 14%. The company’s beta is 1.50.
  • New preference shares can be sold at Sh. 120 per share with a dividend of Sh. 12 per share; and floatation costs of Sh.6 per share.
  • The corporation tax rate is 30%.
  • The company pays out all its earnings as dividends.
  • The company will sell 12% debentures with a maturity of 10 years at Sh.90 per debenture. The par value of the debenture is Sh.100.

Required: 

Using market values, calculate the weighted average cost of capital (WACC) of Ngana Ltd

 

 

QUESTION 3
  •  Digital Ltd. projects to raise Sh.50 million for construction of a new plant. After due consideration, the financial manager proposed the following three financial plans.

 

  • Issue of 5,000,000 ordinary shares at Sh. 10 each.
  • Issue of 2,500,000 ordinary shares at Sh.10 each and 250,000 debentures of Sh.100 each bearing 8% rate of interest per annum.
  • Issue of 2,500,000 ordinary shares at Sh. 10 each and 250,000 preference shares at Sh. 100 each bearing 8% rate of interest per annum.

The company’s tax rate is 30%.

 

Required:

  • Earnings per share (EPS) when the company earnings before interest and tax are Sh. l million, Sh.2 million,Sh.4 million, Sh.6 million and Sh.10 million, under each of the three financial plans.
  • Advise the management of Digital Ltd. on the best financial plan in (b) (i) above.

 

QUESTION 4
  1. a) The capital structure of Savy Ltd. is as follows:

       Sh.”000″ 8,000,000 ordinary shares of Sh. 10 each         80,000 4,000,000 12% preference shares of Sh. 10 each        40,000

16% long-term loan 5,000 18% debentures   3,000

128,000

Additional information:

  • Ordinary shares are currently quoted at Sh. 14 on the securities exchange.
  • Ordinary shares have a dividend cover of 3 times and an earnings per share (EPS) of Sh.6.
  • The 18% debentures were issued in 2006 at a price of Sh.l 00. They are due for redemption in 2014 at sh. 120
  • The company incurred Sh. 400,000 in floatation costs when raising the loan.
  • The company’s tax rate is 30%.

 

Required:

  • The company’s growth in equity.
  • The company’s weighted average cost of capital (WACC). 
QUESTION 5
  1. a) The following data show the capital structure of Samma Ltd.

 

Sh. “000”
10% sh. 1,000 debentures

Ordinary share capital

Retained earnings

4,900

18,000

6,000

 

The management of Samma Ltd. intends to invest in a project estimated to cost sh.16, 800,000.

The cost of the project will be raised as follows:

  • Issue 10% 100 debentures at the current price of sh. 5,000.
  • Issue 10% sh. 20 preference shares at the market price of sh. 25.
  • Issue ordinary shares at the current market price of sh. 45 with floatation cost of 12%.
  • Utilise 60% shares at the current market price of sh. 45. with floatation cost of 12%

 

The company’s current dividend yield is 5% while the tax rate is 30%.

Required: 

The weighted marginal cost of capital.

QUESTION 6

The following data is available for Firm A

 

Firm A
Quantity

Selling price

Variable cost

Fixed costs

Interest

Preferred dividend

Tax rate

20,000 units Sh. 20

Sh. 15

Sh. 40,000

Sh. 10,000

Sh. 5,000 30%

 

Required: 

  • Overall break – even point in units.
  • Degree of operating leverage. iii. Degree of financial leverage. iv.   Degree of total leverage.

 

June 2013 Question Two C

QUESTION 7
  •  Differentiate between the following sets of terms:
  • “Real interest rate” and “nominal interest rate”.
  • “Running yield and “flat yield”.
    QUESTION 7
    •  Difference between the following sets of terms;
    • Real interest rate – This is the money rate of interest minus the expected rate of inflation. It indicates the interest premium in terms of real goods and services that one must pay while nominal interest rate is the rate of interest that compensates investors for the inflation premium and investor preference for current versus future real consumption.
    • Running yield is the annual income on an investment divided by its current market value. Also called current return, current yield or yield to maturity while flat yield is the annual coupon payment divided by the current price of a bond.

    June 2013 Question One A

June 2013 Question One A

 

 

QUESTION 8
  • Explain the following terms as used in capital structure of a firm:
    • Operating leverage.
    • Financial leverage.
  • Highlight three reasons why accounting profit might not be the best measure of a company’s achievement.
  • Distinguish between the following sets of terms:
    • Disintermediation and intermediation.
    • Mutual funds and hedge funds.
      QUESTION 8
      • Terms used in capital structure:
        • Operating leverage

      Refers to the ratio of contribution (sales less variable costs) to profit before interest and tax. Measured using a degree of operating leverage. It shows the sensitivity of forms operating income to changes in sales.

       

      • Financial leverage

      Refers to the ratio of profit before interest and tax (PBIT) to profit after tax. It is also the ratio of total debt to total assets. It is the degree to which an investor is utilizing borrowed money. Also known as financial gearing measured using degree of financial gearing. Shows the sensitivity of the firms earning per share to changes in operating income.

      • Reasons why accounting profit might not be the best measure of a company’s achievement. – Risk-profit does not take into account risk
        • Short-term performance – profits focus on the short-term
        • Manipulation – accounting profits can be manipulated
        • Volume of investment – profits on their own do not take into account the volume of investment.
        • Profits include non-cash terms.
      • Disintermediation is a pattern of funds flow where investors withdraw funds from financial intermediaries such as banks and invest the funds directly in the market place, because they can obtain a higher yield.

      Intermediation is the process of linking units with deficit funds with those with surplus by financial intermediaries. The flow of funds through financial intermediaries.

      (ii) Mutual funds are financial intermediaries that pool the financial resources of investors and invest those resources in diversified portfolio of securities.

      Hedge fund is an investment fund that can undertake a wider range of investment and trading activities than other funds which are generally only open to certain types of investors specified by

      regulations.

       

QUESTION 9
  1. b) Moran Ltd. earnings and dividend per share have been growing at a rate of 18% per annum. This rate is expected to be constant for four years, after which it will fall to 12% for another four years. Thereafter, the growth rate will be 6% in perpetuity. The last dividend per share to be paid was Sh.2 and the investors’ required rate of return is 15%.

 

Required:

The intrinsic value per share.

QUESTION 10

  1. Rock Ltd. is planning to issue 10 million Sh.0.25 shares with a current market price of Sh. 1.55 cum-dividend. An annual dividend of Sh.0.09 has been proposed. The company earns an accounting rate of return on equity (R.O.E) of 10% and a dividend payout of 40%. The company also has 13%. Sh. 100 redeemable debentures with a nominal value of Sh.7 million, trading at Sh. 105. The debentures are due to be redeemed at par in five years’ time. Assume a corporation tax rate of 30%.

 

Required:

The weighted average cost of capital (WACC) of the company.

 

Chairimani Ltd. is contemplating to issue 8% bonds redeemable at Sh.100 par value in three years’ time. Alternatively, each bond may be converted on that date into 30 ordinary shares of the company. The current market price per share is Sh.3.30 and this is expected to grow at 5% per annum into perpetuity. The company’s cost of debt is 6% per annum.

 

Required:

  • Market value of the bond.
  • Floor value of the bond.
  • Conversion premium per share.

 

QUESTION 11
  1. c) Laura Ltd intends to raise Sh.25 million to finance a new project through a rights issue. The project has a 10 year economic life with ho salvage value and is expected to generate annual cash inflows of Sh.7, 372,280. The company has 4 million issued and fully paid shares. The cost of capital is 15% and before the announcement of the rights issue, the market price per share was Sh.

18.



 

Required:

The cum-rights market puce per share

November 2011 Question Three C

QUESTION 12

Explain the meaning of the term “enterprise value” in the context of the valuation of a business entity.

QUESTION 12

 The meaning of the term ‘enterprise value’ in the context of business entity

A measure of a company’s value, often used as an alternative to straight forward market capitalization. Enterprise value is calculated as market cap plus debt, minority interest and preferred shares, minus total cash and cash equivalents.

 

QUESTION 13

The optimal capital structure of DP Ltd. is as shown below.

 

Sources of capital Weight
%
Long term debt 40
Preference share capital 10
Ordinary share capital 50

 

The company is contemplating selling sh. 10 million worth of 20 – year 9% bonds with sh.1,000 par value. The market price of the bond is currently sh. 980. Assume a tax rate of 30%.

 

In addition, the company will issue 10% preference shares (sh. 100 par value) that are expected to sell at sh.87 each incurring sh. 5 per share in floatation costs. Ordinary shares, currently priced at sh. Sh. 50 per share will also be issued Next year, the company expects to pay dividend of sh. 4 per share. Past dividend patterns are as follows;-

 

Year  Dividend per share
2010 3.8
2009 3.62
2008 3.47
2007 3.33
2006 3.12
2005 2.97

 

A new issue of ordinary shares will attract sh. 3 discount and a floatation cost of sh. 2.5 per share.

 

The company has sh. 300,000 in retained earnings and is considering investing in a project which will cost sh. 1,200,000

 

Required: 

  • The marginal cost of capital (MCC) assuming a 30% tax rate.
  • Retained earnings break point.

June 2011 Question Three 

 

QUESTION 14

The objective of financial management is to maximise the value of the firm”.

 

Required:

Explain how the achievement of this objective might be compromised by the conflict which may arise between the organisations.

QUESTION 14

The objective of financial management is to maximize the value of the firm.

Explain how the achievement of this objective might be compromised by the conflict which may arise between the various stakeholders in the organization. 

 

Managers prefer low risk- low return investment since they have a personal fear of losing their jobs if the projects collapse. (Human capital is not diversifiable). This difference in risk profile is a source of conflict of interest since shareholders will fore go some profits when low return projects are undertaken.

 

Dividends may be paid from current net profit and the existing retained earnings. Retained earnings are an internal source of finance. The payment of high dividends will lead to low level of capital and investment thus reduction in the market value of shares and the bonds.

 

Managers might undertake projects which are profitable in the short run. Shareholders on the other hand evaluate investments in the long run horizon which is consistent with the going concern aspect of the firm. The conflict will therefore occur where management pursue short term profitability while shareholders prefer long term profitability.

 

Consumption of perquisites;-Perquisites refer to the high salaries and generous fringe benefits which the directors might award themselves. This will constitute directors remuneration which will reduce dividends paid to the ordinary shareholders. Therefore the consumption of perquisites is against the interest of shareholders since it reduces their wealth.

 

 

QUESTION 15

Explain the meaning of the term “opportunity cost of capital

QUESTION 15

 Meaning of the Opportunity cost of capital

This is the minimum required rate of return by providers of long term capital; ordinary shareholders, preference shareholders and debenture holders. This minimum required rate of return compensates interest for fore gone benefits. It is the discounting rate.

QUESTION 16

Pick Ltd has the following capital structure which is considered optimal.

 

 

Debt (par @sh.100)

Prefered stock (par @sh100)

Common stock (par @ sh.100)

Sh.’000’ 250,000

150,000 600,000

 

The investors of Pick ltd expect earnings and dividends to grow at a constant rate of 9% in the future. The company has just paid a dividend of sh.3.6 per share and its stock currently sells at a price of sh.60 per share. Treasury bonds yield 11% and the return on the market is 14%.Pick ltd beta is 1.51

 

New preferred stock can be sold at sh.100per share with a dividend of sh.11 per share and flotation costs of sh.5 per share.

The company’s tax rate is 30%and it pays out all its earnings as dividend.12% debentures with a maturity of 10 years can be sold at sh.92 per debenture

 

Required

The weighted average cost of capital (WACC) using market values

 

 

QUESTION 17

The capital structure of Jmaa Ltd. Which is considered optimal, as at 30 September 2009 was as follows :

 

Shs. “000”
Ordinary share capital 360,000
Returned earnings 120,000
8% preference share capital (sh. 100 each par value) 120,000
12% debenture ( sh. 1,000 each par value) 200,000
800,000

 

The company intends to raise additional funds for investing in a new project which is estimated to cost sh. 240 million.

 

Additional information: 

  • Any new ordinary shares issued will incur a 12% floatation cost per share.
  • The most recent ordinary dividend per share was sh. 5.
  • The past and expected future earnings growth rate is 10%. The earnings growth rate is expected to be matched with growth rate in dividends.
  • The current dividend rate is 6.25%.
  • The company expects to raise a maximum of sh. 36 million from retained earnings to finance the project.
  • Additional 8% preference shares can be issued at the current market price of sh. 80 per share.
  • A new 12% debenture can be issued at sh. 960 for each debenture through the stock exchange.
  • Corporation tax rate is 30%.

 

Required: 

  • The current market price per ordinary share.
  • The number of ordinary shares that should be issued to finance the project.
  • The company’s weighted marginal cost of capital (WMCC)

 

QUESTION 18

Limitations of using the weighted average cost of capital in evaluating the firms new projects     The assumptions made under this method of computation aren’t really true in the evaluation of new projects. Like the assumptions that proportion of debt and equity remain unchanged, the opening risk of the firm is unchanged and the finance is not project specific. The reality is that all these aspects change

  1. b) Karatasi Ltd. had the following capital structure as at 31 December 2008.
“sh. “000”
Ordinary share capital (sh. 20 par value) 10,000
Retained earnings 12,000
12% preference share capital (sh. 10 par value) 4,800
10% debentures (sh. 1,000 par value) 7,200
34000

 

Additional information:

  • The current market price per ordinary share, preference share and debenture is sh.. 50, sh. 24

and sh. 1,200 respectively.

  • For the year ended 31 December 2008, the company paid an ordinary dividend of sh. 6.00 per share. Analysts estimate that the company’s earnings and dividends will grow at an annual rate of 15 per cent indefinitely.
  • The corporation tax rate is 30 per cent.

 

Required;-

The company’s market weighted average cost of capital.

QUESTION 19

Jasmin Ltd. a quoted company intends to raise sh. 14,000,000 to finance a capital project. The company is considering issuing the following securities in order to raise the required amount.

  • 200,000 ordinary shares at the ex- div market price subject to a 10% floatation cost per share. The company’s issued shares are currently trading at sh. 32.40 per share cum – div. Dividends for the year ended 31 December 2008 have not yet been paid to shareholders.
  • 40,000 12% debentures at the current market price of sh. 80 per debenture. The par value of each debenture is sh. 100.
  • 100,000 10% preference shares at the current par value of sh. 20 per share.

 

The balance of the capital required would be obtained from retained earnings.

 

  Additional information:

The company declared ordinary dividends over the past five years as follows:

Year ended 31 December Dividend declared
Sh. “000”
2008 24,000
2007 22,320
2006 20,500
2005 19,000
2004 18,310
  • Ordinary dividends are expected to grow into future at a rate equivalent to the average annual growth rate over the past five years.
  • The current number of issued ordinary shares is 10 million.
  • Corporation rate of tax 30%.

 

Required:

  • Ex – div market price per ordinary share.
  • Cost of capital for each component of additional finance. iii) Marginal cost of capital of the company.
  •  Comment on the application of the marginal cost of capital obtained in b(iii) above.
    • Ways that Jasma Limited in (b) above could be used to issue additional ordinary shares
    • Public issue by prospectus
    • Private placing
    • Stock exchange placing
    • Stock exchange introduction
    • Offer for sale
QUESTION 20

Distinguish between weighted average cost and marginal cost of capital.

QUESTION 20

 Distinguish between weighted average cost and marginal cost of capital

 

    • WACC-The overall or composite cost of existing capital from various sources based on % cost and market value weights.
    • MCC – overall or composite cost of new or additional capital based on % cost of new capital and weight based on amount from each source relative to total new capital.
    • The following was the capital structure of Fahari Ltd. as at 31 October 2007.

 

Sh.
Ordinary share capital 10.0 million
12% preference share capital (sh. 20 par) 4.8 million
10% debentures (sh. 1,000 par) 3.6 million

 

Additional information:

  • The market prices per ordinary share, preference share and debenture were sh. 45, and sh. 30

and sh. 1,200 respectively on 31 October 2007.

  • The dividend per ordinary share for the year ended 31 October 2006 was sh. 8.00. Dividends are expected to grow at an annual rate of 12 percent.
  • The rate of corporation tax is 30 per cent.

 

Required:

The weighted average cost of capital (WACC) of fahari Ltd. Use market value weights

 

 

QUESTION 21
  • Distinguish between the marginal cost of capital and the weighted average cost of capital.
  • Upendo Ltd. is in the process of raising additional finance. The company’s financial structure comprises ordinary share capital, reference share capital, debenture capital and retained earnings. Each of these sources of finance is analyzed below:

 

Ordinary Share Capital

  • The current market price per share is Sh.80
  • The company expects to pay a cash dividend of Sh.6 per share in the next financial year
  • The annual rate of growth in dividend per share is 6%
  • Flotation costs amounting to Sh8 per share

 

 11% Preference Share Capital

  • The par value per share is Sh.100
  • The share are currently trading at par
  • Flotation costs amounting to Sh.4 per share

 

10% Debenture Capital

  • The per value is Sh1,000 for each debenture stock
  • The debenture have ten-year maturity period
  • The flotation cost for each debenture stock is Sh.50

 

Retained Earnings

  • The company expects to have Sh.225,000 of retained earnings available for the next financial year.
  • Should the retained earnings balance to exhausted, the company will use common stock as the form of equity financing

 

Additional Information;-

  1. The target capital structure is as follows

Source of Capital                                 Weight

Debentures                                             40%

Preference Shares                                   15%

Equity                                                    45%

100%

 

  • The corporation tax rate is 30%

 

Required:

  • Calculate the cost of Capital for ordinary share capital, preference share capital, debenture capital and retained earnings
  • Calculate the marginal cost of capital applying the target capital proportions and using retained earnings to represent equity finance
  • Comment on the relevance of the marginal cost of capital in (ii) above to Upendo Ltd.
    1. ii) Comment: The MCC reflect the average cost of acquiring new funds in order to finance new project. It will therefore be used as a discounting rate for evaluating new projects it will be made as follows:

     

    If IRR >Cost of capital (MCC) – Accept

    IRR < Cost of capital (MCC – Reject

    IRR = Cost of capital (MCC –Indifference

 

 

QUESTION 22
  • Distinguish between compounding and discounting of cash flows.
    QUESTION 22
    • Distinction between compounding and discounting of cashflows

    Compounding is the process of determining the future value of amount of money held at present.

    Discounting on the other hand refers to the process of determining the present value of amount of

    money to be received at some future date.

  • Mount Elgon Ltd. is considering the launch of a new product. Exel, for which an investment of Sh.6,000,000 in plant and machinery will be required. The production of Exel is expected to last five years after which the plant and machinery would be sold for Sh. 1,500,000.

 

  Additional Information:

  • Exel would be sold at Sh.600 per unit with a variable cost of Sh240 per unit
  • Fixed production costs (excluding depreciation) would amount to Sh.600,000 per annum
  • The Company applies the straight line method of depreciation
  • The cost of capital is 10% per annum
  • The units of Exel expected to be sold per annum for the next five years as shown below

            Year:                             Units expected to be sold

1                                                8,000    2                                                7,000    3                                                7,000

4     5,000  5                                                     3,000

  • The corporation tax rate is 30%

 

Required:

  • Calculate the net present value (NPV) of the project and advise the management on the appropriate course of action. ii. Calculate the internal rate of return (IRR) of the project and advise the management on the appropriate course of action.

iii.    Outline the main drawbacks of the IRR method of investment.

  • Main draws backs of the IRR method:
    • It is tedious and time consuming to compute
    • In some instances it gives conflicting results with the NPV technique when ranking mutually exclusive projects
    • In some cases there might be more than one internal rate of return for the same project
    • Some managers confuse the IRR with the ARR

 

QUESTION 23
  • Explain the advantages of using market value weights over book value weights in computing the weighted average cost of capital
    QUESTION 23
    •  Advantages of using the market value weights
    • Investments are rated by investors using their returns which are ascertained using the market values of such investment.
    • When investors acquire investment they pay market prices of such investment and will always compare the viability of their investment using market prices.
    • Historical book values may not represent the true valuation of capital employed as shown in the balance sheet. iv) Use of market value weights is more accurate especially for new issues of shares and debentures.
    • v) The assets used by capital providers as security are valued at market price for collateral purposes.
  • The following information was extracted from the books of Faida Limited as at 31 December 2005.

                                                                                         Sh.

Ordinary Share capital (par value Sh. 25)    800,000 8% Preference share capital (par value Sh.24)   600,000 10% Preference Share capital (par value Sh. 20) 400,000

10% Debenture                                                                400,000

  2,200,000   Additional Information

  1. The Share prices as at 31 December 2005 were as follows:-

Market Price per share         

(Sh.)

Ordinary shares          30 8% Preference Shares     20

10% Preference Shares           25

The market value of the 10% debenture on 31 December 2005 was Sh. 500,000

  • The corporation tax rate is 30%
  • The company has maintained payment of an ordinary dividend per share of Sh. 3.80 over the past five years.

 

Required:

  • Cost of ordinary share capital.
  • Cost of 8% preference share capital. iii. Cost of 10% preference share capital. iv. Cost of 10% debentures.
  • Market –weighted average cost of capital

 

 

QUESTION 24
  •  Distinguish between the following terms. ii) Weighted average cost of capital and marginal cost of capital iii) Finance lease and operating lease
    QUESTION 24
    • i) Difference between WACC and MCC
                     WACC MCC
    1.   It is an historical cost of funds already      employed by the company.

    2.   It is used in evaluating the company’s      existing projects i.e. as a discounting      rate for the existing project.

    3.   Since it is an historical cost it does not      consider floatation costs.

    4.   It uses the market values to determine      the proportion or weight.

    5.   It does not consider the cost of retained earnings since it is already included in the market value of ordinary shares.

     

     

    1.

     

     

    2.

     

     

    3.

     

    4.

     

     

    5.

    It is the average cost of new incremental funds to be acquired by the company. It is used in evaluating the company’s new projects i.e. as a discounting rate for new projects.

    Since it is the cost of new funds to be acquired it considers floatation costs.  It uses the optimal capital structure using book values to determine the weights.

    It considers the cost of retained earnings since it is not included in the book value of ordinary shares.

 

1.   It is an historical cost of funds already      employed by the company.

2.   It is used in evaluating the company’s      existing projects i.e. as a discounting      rate for the existing project.

3.   Since it is an historical cost it does not      consider floatation costs.

4.   It uses the market values to determine      the proportion or weight.

5.   It does not consider the cost of retained earnings since it is already included in the market value of ordinary shares.

 

ii) Finance lease and operating lease 

1.

 

 

2.

 

 

3.

 

4.

 

 

5.

It is the average cost of new incremental funds to be acquired by the company. It is used in evaluating the company’s new projects i.e. as a discounting rate for new projects.

Since it is the cost of new funds to be acquired it considers floatation costs.  It uses the optimal capital structure using book values to determine the weights.

It considers the cost of retained earnings since it is not included in the book value of ordinary shares.

Finance lease Operating lease
               –    Long term (at least 90% of asset life). –   short-term

–   revocable

–   Borne by the owner (lessor) of asset.

–   No option.

–   Not cancelable

–   Operating, maintenance and insurance costs borne by lessee.

–   Option to buy asset at end of lease period.

 

QUESTION 25
  • Define the following finance term
  •  Term of structure of interest rates

Script dividends  iv) Shares splits

QUESTION 25
  •  Definition
  • Term of structure of interest rates: This term refers to a collection or an array of interest rates relating to different maturity period
  • Scrip dividends: Scrip dividends are also known as bonus shares. These are free shares issued from retained earnings to ordinary shareholders.

Shares splits: Share split is where a block of shares is broken down into smaller units so that the number of ordinary shares increases and the respective per value decreases at the stock split factor

  • Zatex ltd, had the following capital structure as at 31 March 2005

                                                                                    Sh.

Ordinary share capital (200,000 Shares)         4,000,000 10% Preference Share Capital       1,000,000

14% Debenture Capital 3,000,000 8,000,000

 

Additional Information;-

  • The market price of each of ordinary share as at 31 March 2005 was Sh.20
  • The company paid a dividend of Sh.2 for each ordinary share for the year ended 31 March 2005
  • The annual growth rate in dividends is 7%
  • The corporation tax rate is 30%

 

Required:

  1. Compute the weighted average cost of capital of the company as at 31 March 2005.
  2. The company intends to issue a 15% Sh.2 million debenture during the year ending 31 March 2006. The existing debentures will not be affected by this issue. The dividend per share for the year ending 31 March 2006 is expected to be Sh.3 While the average market price per share over the same period is estimated to be Sh.15. The average annual growth rate in dividend is expected to remain at 7%.

Compute the expected weighted average cost of capital as at 31 March 2006.

 

 

QUESTION 26
  • Highlight four uses of the cost of capital to Limited Liability Company.
    QUESTION 26
    • a) Uses of cost of capital.
    • Capital budgeting/investment decision.
    • When using NPV as a method of project appraisal cost of capital is used as a discounting rate.
    • When using IRR the cost of capital is compared with the IRR to determine whether to accept or reject the project.
    • Capital structure decisions

    –     The proportion of the different components of capital will depend on the cost of capital of each capital components e.g. if the cost of retained earnings is lowest the firm should have more retained earnings in the capital structure.

    • Evaluation of performance
    • A higher cost of capital is an indicator of high riskiness of the firm due to poor performance.
    • Conversely a low cost of capital indicates low risk and good performance by the firm.
    • Inference on dividend policies of the firmg. If the cost of retained earring is low the firm will pay less dividend and retain more to finance future investment opportunities.
  • The finance manager of Mapato limited has compiled the following information regarding the company’s capital structure.

 

Ordinary Shares

The company’s equity shares are currently selling at Sh. 100 per share. Over the past five years, the company’s dividend pay-outs which have been approximately 60% of the earnings per share, were as follows

Year ended 30 September                 Dividend per Share

Sh.

2004                                                               6.60

2003                                                               6.25

2002                                                               5.85

2001                                                               5.50

2000                                                               5.23

The dividend for the year ended 30 September 2004 was recently paid.

The average growth rate of dividend is 6% per annum

To issue additional ordinary shares, the company would have to issue at a price of Sh.3 per share and it would cost Sh.5 in floating costs per share.

 

Debt

The company can raise funds by selling Sh.100, 8% coupon interest rate, 20-year bonds, on which annual interest will be made.

The bonds will be issued at a discount of Sh.3 per bond and a floatation cost of an equal amount per bond will be incurred.

 

Capital Structure

The company’s current capital structure, which is considered optimal, is:

Sh.

Long term debt  30,000,000 Preference Shares      20,000,000 Ordinary Shares       45,000,000

Retained Earnings                                                   5,000,000

100,000,000 The company is in the 30% tax bracket.

 

Required:

  • The specific cost of each source of financing. ii) The level of total financial at which a break-even point will occur in the company’s weighted marginal cost of capital.

 

QUESTION 27
  • Explain the meaning of the term “Cost of capital” and explain why a company should calculate its cost of capital with care.
    QUESTION 27
    • The cost of capital is the required rate of return by all the investors who have provided funds to the company. The investors who provide funds to companies include: equity shareholders, debenture holders and preference shareholders. The average cost of capital to the company is known as the overall cost of capital or the composite cost of capital of weighted average cost of capital. The company has to calculate the WACC with a lot of care because the WACC is used as follows:
      • To determine the companies cost of borrowing.
      • As a discounting rate for the company’s existing projects.
      • For comparison with other similar companies in the same industry.
      • To determine the general risk level of the company.

     

  • Identify and briefly explain three conditions, which have to be, satisfy before the use of the weighted average cost of capital (WACC) can be justified.          Before calculating WACC the following should be done
    • Calculate the component cost of each source of finance already employed by the company.
    • Determine the values to be used in calculating WACC. There are normally 3 Values which can be used in calculating WACC i.e. the book values, the target values and the market values: The recommended values for calculating WACC are the market values since they reflect the current market conditions under which new funds may be raised.
    • Determine the uses into which WACC could be put into WACC is normally used in evaluating the company’s existing projects since it is an average historical cost of the funds already employed by the company.
Sh.‘000’
Long-term debt

Ordinary Share Capital

Retained earning

3,600 6,500 4,000

Biashara Ltd, has the following capital structure

 

 

The finance manager of Biashara Ltd. has a proposal for a project requiring Sh.45 million. He has proposed the following method of raising the funds.

  • Utilise all the existing retained earning.
  • Issue ordinary share at the current market price.
  • Issue 100,000 10% preference shares at the current market price of Sh.100 per share which is the same as par value.
  • Issue 10% debentures at the current market price of Sh.1,000 per debenture

 

Additional Information:

  • Currently Biashara Ltd. Pays a dividend of Sh5 per share which is expected to grow at the rate of 6% due to increased returns from the intended project. Biashara Ltd.’s. price/earnings (P/E) ratio and earnings per share (EPS) are Sh5 and Sh.8 respectively.
  • The ordinary share would be issued at a floatation cost of 10% based on the market price
  • The debenture par value is Sh.1,000 per debenture
  • The corporate tax rate is 30%

 

Required:

Biashara Ltd.’s weighted average cost of capital (WACC)

 

QUESTION 28
  • Explain why the weighted average cost of capital of a firm that uses relatively more debt capital is generally lower than that of a firm that uses relatively less debt capital.
    QUESTION 28

    The WACC for a firm that uses more debt is lower than that of the firm that uses less debt capital because the cost of debt is always cheaper than the cost of equity. This is because interest on debenture is a tax allowable expense i.e. it provides the company with an interest tax shield. Thus the use of more debt means more tax shield or more use of cheaper source of finance hence a reduced WACC.

  • The total of the net working capital and fixed assets of Faida Ltd. As at 30 April 2003 was Sh. 100,000,000. The company wishes to raise additional funds to finance a project within the next one year in the following manner:

Sh. 30,000,000 from debt

Sh. 20,000,000 from selling new ordinary shares

 

The following items make up the equity of the company:

 

3,000,000 fully paid up ordinary shares           30,000,000 Accumulated retained earning           20,000,000 1,000,000 10% Preference shares           20,000,000

200,000   6% long term debenture                   30,000,000

 

The current market value of the company’s ordinary shares is Sh. 30. The expected dividend on ordinary shares by 30 April 2004 is forecast at Sh. 1.20 per share. The average growth rate in both earnings and dividends has been 10% over the last 10 years this growth rate is expected to be maintained in the foreseeable future

 

The debenture of the company has a face value of Sh. 150. However, they currently sell at their face value.

Assume a tax rate of 30%

 

Required:

  •  The expected rate of return on ordinary share
  • The effective cost to the company of: Debt capital
  • Preference share capital
  •  The company existing weighted average cost of capital.
  •  The company’s marginal cost of capital if it raised the additional Sh. 50,000,000 as intended.

 

QUESTION 29
  • Explain the term “agency costs” and give any three examples of such costs.
    QUESTION 29
    •  Agency costs

    These are cost borne by shareholders of an organization as a result of not being directly involved in decision making, when the decisions are made by the directors. Agency costs are incurred when management decisions are based on the interests of directors rather than shareholders.

     

    Examples of agency costs;-

    • Expenditure for external audit incurred by the organization
    • Installation of systems of internal control and internal audit
    • Opportunity costs of foregone projects which are perceived by management to be too risky. ‘Perks” and incentives paid by the organization to make directors act the best interests of shareholders.

     

  • On 1 November 2002, Malaba Limited was in the process of raising funds to undertake four investment projects. These projects required a total of Sh.20 million.

 

Given below are details in respect of the projects:

 

Project                       Required Initial Investment        Internal Rate of Return

Shs. million                                 (IRR)

  • 7 24%
  • 6 16%
  • 5 18%
  • 2 20%

 

You are provided with the following additional information:

 

  • The company had Sh.5.4 million available from retained earnings as at 1 November 2002. Any extra equity finance will have to be sourced through an issue of new ordinary shares.
  • The current market price per share on 1 November 2002 was Sh.22.40, ex-dividend information on Earnings Per Share (EPS) and Dividends Per Share (DPS) over the last 6 years is as follows:

 

Year ended 31 October        1997 1998       1999      2000      2001   2002

 

EPS (Sh.)                            4.20     4.40     4.65       4.90       5.15       5.26

DPS (Sh.)                            2.52     2.65     2.80       2.95       3.10       3.22

 

  • Issue of new ordinary share would attract floatation costs of Sh.3.60 per share.
  • 9% Irredeemable debentures (par value Sh.1,000) could be sold with net proceeds of 90% due to a discount on issue of 8% and floatation costs of Sh.20 per debenture. The maximum amount available from the 9% debentures would be Sh.4 million after which debt could be obtained at 13% interest with net proceeds of 91% of par value.
  • 12% preference shares can be issued at par value Sh.80.
  • The company’s capital structure as at 1 November 2002 which is considered optimum is:

Ordinary share capital (equity) 45% Preference share capital  30%

Debentures                               25%

 

  • Tax rate applicable is 30%.
  • The company has to use internally generated funds before raising extra funds from external sources.

 

Required:

  • The levels of total new financing at which breaks occur in the Weighted Marginal Cost of Capital (WMCC) curve.
  • The weighted marginal cost of capital for each of the 3 ranges of levels of total financing as determined in (i) above.
  • Advise Malaba Limited on the projects to undertake assuming that the projects are not divisible.

 

QUESTION 30
  • Explain fully the effect of the use of debt capital on the weighted average cost of capital of a company.
    QUESTION 30
    • At initial stages of debt capital the WACC will be declining upto a point where the WACC will be minimal. This is because.
      • Debt capital provides tax shield to the firm and after tax cost of debt is low.
      • The cost of debt is naturally low because it is contractually fixed and certain.

    Beyond the optimal gearing level, WACC will start increasing as cost of debt increases due to high financial risk.

  • Millennium Investments Ltd. wishes to raise funds amounting to Sh.10 million to finance a project in the following manner:

Sh.6 million from debt; and

Sh.4 million from floating new ordinary shares.

 

The present capital structure of the company is made up as follows:

 

  • 600,000 fully paid ordinary shares of Sh.10 each
  • Retained earnings of Sh.4 million
  • 200,000, 10% preference shares of Sh.20 each.
  • 40,000 6% long term debentures of Sh.150 each.

 

The current market value of the company’s ordinary shares is Sh.60 per share.  The expected ordinary share dividends in a year’s time is Sh.2.40 per share.  The average growth rate in both dividends and earnings has been 10% over the past ten years and this growth rate is expected to be maintained in the foreseeable future.

 

The company’s long term debentures currently change hands for Sh.100 each.  The debentures will mature in 100 years.  The preference shares were issued four years ago and still change hands at face value.

 

Required:

  • Compute the component cost of:

Ordinary share capital;  –    Debt capital

–     Preference share capital

  • Compute the company’s current weighted average cost of capital.
  • Compute the company’s marginal cost of capital if it raised the additional Sh.10 million as envisaged.  (Assume a tax rate of 30%).

 

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