Financial management revision question and answer

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
Shs. million Internal Rate of Return
(IRR)
A 7 24%
B 6 16%
C 5 18%
D 2 20%

You are provided with the following additional information:

1. 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.
2. 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

3. Issue of new ordinary share would attract floatation costs of Sh.3.60 per share.
4. 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.
5. 12% preference shares can be issued at par value Sh.80.
6. 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%

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

Required:

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


Weighted marginal cost of capital for each of the ranges of financing:


Cost of preference shares


For the range 12m 16m

Only cost of equity changes since extended equity is to be raised. Thus.

For the range 16m 20m

Cost of equity (Ke)

Cost of preference shares (Kp)


(iii) Graphical illustration of WMCC/investment projects‟ IRR and level of financing.

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