Financial management revision question and answer

The financial data given below shows the capital structure of Akabebi Company Limited.

The structure is considered optimum and the management would wish to maintain this level.

Akabebi Company Limited intends to invest in a new project which is estimated to cost Sh.16,800,000 with an expected net cash flow of Sh.3,000,000 per annum for 10 years. The management has proposed to raise the required funds through the following means:

1. Issue 100 10% debentures at the current market value of Sh.5,000 per debenture.
2. Utilise 60% of the existing retained earnings.
3. Issue 10% Sh.20 preference shares at the current market price of Sh.25 per share
4. Issue ordinary shares at the current market price of Sh.45 per share. Floatation cost per share is estimated to be 12% of the share value.
The company‟s current dividend yield is 5% which is expected to continue in the near future. Corporation tax rate is 30%.

Required:
(a) Determine the current dividend per share. (3 m
(b) Determine the number of ordinary shares to be issued.
(c) Determine the marginal cost of capital for Akabebi Company Ltd based on the above information.
(d) Evaluate whether it is viable to invest in the proposed project (Round off your answer for cost of capital to the nearest 1)
(e) Explain clearly the sense in which depreciation is said to be a source of funds to business firms.
answer
Since the company is raising new K determine the amount to raise from each source. The amount from debentures and Retained Earnings are specified.
The amount to raise from ordinary shares can be derived from the existing capital structure.


The issue price of ordinary shares is the current MPS net of floatation costs.

MPS 45.00
Fixed cost = 12%x45 5.40
Po-Fc = MPS net of fixed cost 39.60

Number of shares to be issued to raise Sh.10.464M from issue of ordinary shares at
39.60 MPS
(c) Marginal cost of capital
For each of the 4 sources of capital compute the percentage MC. Ret Earnings are now a source of capital and hence the need to get the cost of Retained Earnings Kr but does not involve any floatation cost.

(i) Marginal Cost of debenture (Kd)
No maturity period is given for debenture to be issued thus they are perpetual.


(ii) M Cost of Retained Earnings (Kr)

Retained Earnings should have been paid out as dividends. Therefore Kr is the percentage opportunity cost to the shareholders who should have received the dividends. It is therefore based on dividend paid just like Ke. However, no floatation costs are involved. No growth rate is given in the question thus use a zero growth dividend yield model where:


(iii) Marginal Cost of Ordinary Share Capital (Ke)


(iv) Marginal Cost of Preference Share Capital (Kp)


(e) Depreciation as a source of finance to the firm in 2 ways:(i) It is tax allowable thus will yield a tax shield/saving to the firm since it reduces firms tax liability.
(ii) Provision for depreciation is an appropriation from the company‟s profits. This appropriation is transferred to a sinking fund which becomes a source of capital for replacing an existing asset. It is an internal source of finance.

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