Financial management revision question and answer

The Salima company is in the fast foods industry. The following is the company‟s balance sheet for the year ended 31 March 1995:


Additional information:
1. The debenture issue was floated 10 years ago and will be due in the year 2005. A similar debenture issue would today be floated at Sh.950 net.
2. Last December the company declared an interim dividend of Sh.2.50 and has now declared a final dividend of Sh.3.00 per share. The company has a policy of 10% dividend growth rate which it hopes to maintain into the foreseeable future. Currently the company‟s shares are trading at Sh.75 per share in the local stock exchange.
3. A recent study of similar companies in the fast foods industry disclose their average beta as 1.1.
4. There has not been any significant change in the price of preference shares since they were floated in mid 1990.
5. Treasury Bills are currently paying 12% interest per annum and the company is in the 40% marginal tax rate.
6. The inflation rate for the current year has been estimated to average 8%.

Required:
(a) Determine the real rate of return.
(b) What is the minimum rate of return investors in the fast foods industry may expect to earn on their investment? Show your workings.
(c) Calculate Salina‟s overall cost of capital.
(d) Discuss the limitations of using a firm‟s overall cost of capital as an investment discount
rate.
ANSWER
(a) Real rate = risk free rate – inflation rate.

Risk free rate is the interest rate on Treasury bills Real rate = 12% – 8% = 4%
(b) The minimum required rate of return for each investor is the cost of each capital component to the firm.

Cost of preference shares, Kp

Since market price of a preference share is equal to par value then Kp = coupon rate = 15%.

Cost of debentures = (Kd)

The debentures have a maturity period of 20 years (1985 – 2005). Therefore Kd is equal to yield to maturity (YTM)

M = Maturity/redemption value = Sh.1,000
Vd = Market value = Sh.950
n = Interest period = 20 years
Int = Interest after tax = 16%(1 – 0.4) x 1000 = Sh.96


Cost of equity Ke

Since growth rate is given, use dividend yield growth model to determine Ke

(c) Overall or composite cost of Capital is the weighted average cost of capital (WACC). It is based on market values.

(d) Weaknesses of WACC
– It is based on assumption that the firm has an optimal capital structure (mix of debt and equity) which is not achievable in real world.
– Market values of capital will constantly change over time hence change in WACC.
– It can be used as a discounting rate on assumption that the projects risk is equal
to the firm‟s business risk otherwise it will require some adjustment.
– It is based on historical data e.g growth rate in dividends is based on past date. The growth rate cannot be constant p.a. in perpetuity.

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