Financial management revision question and answer

CPA-Financial-Management-Section-3 Revision kit

Mchunguzi Limited has compiled the following information on its financing costs:

Mchunguzi Ltd. is in the 30 per cent tax bracket and has a target debt-equity ratio of 100 per cent. The company managers would like to keep the market values of short-term and long-term debt equal.

(a) The Weighted Average Cost of Capital (WACC) using:
(i) Book-value weights.
(ii) Market-value weights.
(iii) Target-weights.

(b) Explain the differences between the three WACC calculated in (a) above. What are the correct weights to use in the WACC calculation?

(c) Mchunguzi‟s Ltd.‟s subsidiary company, Ottamax Ltd. is considering undertaking a warehouse renovation at a cost of Sh.50 million. The warehouse is expected to yield cost savings of Sh.12 million a year for six years. Ottamax Ltd. has a current debt-equity ratio of 60%, a cost of debt of 25 per cent and a cost of equity of 13.5%. The corporate tax rate for such a firm is 30%.

Using appropriate computation, advise Ottamax Ltd. on whether it should undertake the renovation.

(a) (i)WACC using book value weights:-

(iii) Since the target weights are 50/50 the answer is 10.65% as above.

(b) The differences in the WACCs arise because of the value of the weightings using market value weights gives a higher WACC because equity has a heavier weighting. The market value weights are the right weights to use as they reflect the true value of equity and debt unlike the book value weights which are accounting values and they make use of historical costs.

The project has a negative NPV. This means that the financial markets offer superior projects in the same risk class. The firm should reject the project.

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