Mac3702 Assignment 2
Question 1 Solution
Part A
a) Ordinary shares
Market value = 1 000 000 x (66-6) = 60 000 000
Cost of equity = D1/Po + q
= 6 x 1.08/60 + 0.08
= 18.8%
Debentures
Pmt = 11.11% x 72% x -15 000 000 = -1 199 880
N=5
Fv = -15 000 000
Compt pv = 13 862 309
Preference shares
Fv = -12 000 000 + 5% x 12 000 000 = -12 600 000
N = 10
Interest = 12%
PMT = 9% x 12 000 000 = -1 080 000
Compt pv = 10 159 104
MV Weighting Cost WACC
Ordinary shares 60 000 000 71.41% 18.8% 13.43%
Debentures 13 862 309 16.50% 10% 1.65%
Preference shares 10 159 104 12.09% 12% 1.45%
84 021 413 16.53%
-investors are rational
-capital markets are perfect
-the discount rate assumes that all cash received before the end of the project is reinvested at the
discount rate
, b)
To: Board of directors
From: Mac 3702 student
Date: 14/03/16
Ref: Critical evaluation of the directors’ view on the appropriate funding instrument
Managing director
- Ordinary shares are less riskier than debt finance, since the ordinary dividend is paid when all debt
and preference shares are paid
- it is not mandatory to pay dividends, unlike interest payable on debt instruments, which is
mandatory
-the capital on ordinary shares is not repayable whilst the initial amount borrowed is repayable for
debt finance
- therefore equity finance will be less riskier than the debt finance
Chief operating officer
-cumulative redeemable preference shares cost is 12%, whereas, the cost of debentures is 13.89%
- is seems the preference shares are cheaper but this is not the case as it is an after-tax cost already.
Interest payable on debt instruments results in a tax advantage of 28%
- the cost of debentures after tax will be 10% (13.89 x 72%). Therefore debentures will be cheaper.
Finance director
-to use a mix of debt and equity is cheaper if the intention is to maintain an optimal capital
structure.
When financing projects, the company should maintain its target capital structure so that they will
be liquid and have a positive financial leverage.
Question 1 Solution
Part A
a) Ordinary shares
Market value = 1 000 000 x (66-6) = 60 000 000
Cost of equity = D1/Po + q
= 6 x 1.08/60 + 0.08
= 18.8%
Debentures
Pmt = 11.11% x 72% x -15 000 000 = -1 199 880
N=5
Fv = -15 000 000
Compt pv = 13 862 309
Preference shares
Fv = -12 000 000 + 5% x 12 000 000 = -12 600 000
N = 10
Interest = 12%
PMT = 9% x 12 000 000 = -1 080 000
Compt pv = 10 159 104
MV Weighting Cost WACC
Ordinary shares 60 000 000 71.41% 18.8% 13.43%
Debentures 13 862 309 16.50% 10% 1.65%
Preference shares 10 159 104 12.09% 12% 1.45%
84 021 413 16.53%
-investors are rational
-capital markets are perfect
-the discount rate assumes that all cash received before the end of the project is reinvested at the
discount rate
, b)
To: Board of directors
From: Mac 3702 student
Date: 14/03/16
Ref: Critical evaluation of the directors’ view on the appropriate funding instrument
Managing director
- Ordinary shares are less riskier than debt finance, since the ordinary dividend is paid when all debt
and preference shares are paid
- it is not mandatory to pay dividends, unlike interest payable on debt instruments, which is
mandatory
-the capital on ordinary shares is not repayable whilst the initial amount borrowed is repayable for
debt finance
- therefore equity finance will be less riskier than the debt finance
Chief operating officer
-cumulative redeemable preference shares cost is 12%, whereas, the cost of debentures is 13.89%
- is seems the preference shares are cheaper but this is not the case as it is an after-tax cost already.
Interest payable on debt instruments results in a tax advantage of 28%
- the cost of debentures after tax will be 10% (13.89 x 72%). Therefore debentures will be cheaper.
Finance director
-to use a mix of debt and equity is cheaper if the intention is to maintain an optimal capital
structure.
When financing projects, the company should maintain its target capital structure so that they will
be liquid and have a positive financial leverage.
