Advanced financial management revision question and answer

Jabali Ltd. is a quoted company which is financed 10,000,000 ordinary shares and Sh.50,000,000 of irredeemable 8% debentures. The market value of the shares is Sh.20 each ex-div and an annual dividend of Sh.4 per share is expected to be paid in perpetuity. The debentures are considered to be risk-free and are valued at par.

Mr. Jabali the managing director of the company is wondering whether to invest in a project which cost Sh.20 million and yield Sh.3.8 million a year before tax in perpetuity. The project has an estimated beta value of 1.25. The return from a well-diversified market portfolio is 16%.

Required:
a) The weighted average cost of capital of the company.
b) The beta of the company.
c) The beta of an equivalent ungeared company ignoring taxes.
d) Advise the company whether/or not the project should be accepted. In your explanation, highlight the significance of your calculations in (a), (b) and (c) above.
ANSWER


c) Value of the un-geared beta ignoring tax


d) The required return from a project with a, β = 1.25 is 0.08 + 1.25(0.16 – 0.08) = 0.18
The actual return from the project would be:


This exceed the required yield of 18% and so the project should be undertaken

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