Financial management revision question and answer

Vitabu Ltd. is a merchandising firm. The following information relates to the capital structure of the company:

1. The current capital structure of the company which is considered optimal, comprises: Ordinary share capital – 50%, preference share capital – 10% and debt – 40%.
2. The firm can raise an unlimited amount of debt selling Sh.1,000 par value, 10 year 10% debentures on which annual interest payments will be made. To sell the issue it will have to grant an average discount of 3% on the par value and meet flotation costs of Sh.20 per debenture.
3. The firm can sell 11% preference shares at the par value of Sh.100. However,, the issue and selling costs are expected to amount to Sh.4 per share. An unlimited amount of preference share capital can be raised under these terms.
4. The firm‟s ordinary shares are currently selling at Sh.80 per share. The companyexpects to pay an ordinary dividend of Sh.6 per share in the coming year. Ordinary dividends have been growing at an annual rate of 6% and this growth rate is expected to be maintained into the foreseeable future. The firm can sell unlimited amounts of new ordinary shares but this will require an under pricing of Sh.4 per share in addition to flotation costs of Sh.3 per share.
5. The firm expects to have Sh.225,000 of retained earnings available in the coming year. If the retained earnings are exhausted, new ordinary shares will have to be issued as the form of equity financing.
The company is in the 30% corporation tax bracket.

Required:
(a) The cost of each component of financing.
(b) The level of total financing at which a break in the marginal cost of capital (M.C.C) curve occurs.
(b) The weighted average cost of capital (W.A.C.C):
(i) Before exhausting retained earnings.
(ii) After exhausting retained earnings.
ANSWER

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