Financial management revision question and answer

The total of the net working capital and fixed assets of Faida Ltd as at 30 April 2003 was Sh.100,000,000. The company wishes to raise additional funds to finance a project within the next one year in the following manner.

Sh.30,000,000 from debt
Sh.20,000,000 from selling new ordinary shares.

The following items make up the equity of the company:

3,000,000 fully paid up ordinary shares Sh.
30,000,000
Accumulated retained earnings 20,000,000
1,000,000 10% preference shares 20,000,000
200,000 6% long term debentures 30,000,000

The current market value of the company‟s ordinary shares is Sh.30. The expected dividend on ordinary shares 30 April 2004 is forecast at Sh.1.20 per share. The average growth rate in both earnings and dividends has been 10% over the last 10 years and this growth rate is expected to be maintained in the foreseeable future.

The debentures of the company have a face value of Sh.150. However, they currently sell for Sh.100. The debentures will mature in 100 years.

The preference shares were issued four years ago and still sell at their face value. Assume a tax rate of 30%
Required:
(i) The expected rate of return on ordinary shares. (2 marks)

(ii) The effective cost to the company of:
 Debt capital
 Preference share capital
(iii) The company‟s existing weighted average cost of capital.

(iv) The company‟s marginal cost of capital if it raised the additional Sh.50,000,000
as intended.
ANSWER
i). Expected rate return on ordinary shares is equal to cost of equity, ke Ke –


(ii). Effect of cost os
– Debt kd
– Debentures have a definite maturity period hence


vd = current make value and m = par/maturity value
– cost of preference share capital kp preference shares are selling at par hence market price = par value and kp = coupon rate = 10%

(iii). M.V. of equity = Sh. 30 x 3m shares = 90 m
M.V of debt – Sh. 100 x 0.2m debentures = 20m
M.V. of preferred shares – par value = 20m Total Market Value 130m

Wall = 14% (90/130) + 5.44% (20/130) + 10% (20/130) = 9.69+0.84+1.54
= 12.02%

(iv). No floatation costs one given hence marginal cost of debt and equities is 5.44% 14% respectively
– The amount to raise is 50m where 60% (30m/50m) will from debt and 40% from issue of shares.
– Therefore WACC = (5.44% x 0.6) + (0.4 x 14%) = 8.864%

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