Ridges Company Ltd. is the process of preparing its capital budget for the financial year ending 30 June 2005. The company‟s capital structure as at 1 July 2004 and which the management considers as optimal ispresented below:
The following additional information is available:
1. The company can borrow a Sh.200 million long to on loan at a pre-tax cost 13. Any additional debt can be obtained at a pre-tax cost of 16%.
2. The company can raise Sh.400 million through a bond issue. Each bond will have a face value of Sh.1,000 but will be issued at Sh.687. The coupon rate on the bonds will be 10% with maturity period of twenty years.
3. Preferred stock can be-issued at a pre-tax cost of 16.5%.
4. The company expects to generate Sh.700 million in net income before tax for the year ending 30 June 2005
5. The average annual growth rate in dividends is 5.5% and this rate is expected to continue into the foreseeable future. The company expects to pay an ordinary dividend per share of Sh.10 for the year ending 30 June 2005.
6. The following investment proposals will be available to the company in the year ending 30 June 2005.
7. Assume a corporation tax rate of 30%
a) Determine the cost of capital for each of the following sources of finance:
i) Long-term loan
iii) Additional Debt
iv) Preference share capital
v) Retained earnings
b) Using the marginal cost of capital (MCC) and internal rate of return (IRR) schedules, determine the investment project(s) that should be accepted for the year ending 30 June 2005.
M = Maturity or par or face value
Vd = Current market value
n = Maturity period
iii) Additional debt (unlimited) cost = kd = 16(1 – 0.3) = 11.2%
iv) Cost of preference shares Kp = 16.5% (not tax deductible)
v) Cost of retained earnings, Kr