Question

                    

Part a.

1. While arranging capital for their business some managers follow the pecking order theory, can you explain what pecking order theory is and why managers choose such a theory to raise capital?
2. Calculate the rate of return available to shareholders for a company financing $1 million of assets with the following three arrangements:

1. All equity
2. 50% equity, and 50% debt at an interest rate of 12% per annum.
3. 25% equity, and 74% debt at an interest rate of 12% per annum.

The assets are expected to generate earnings before interest of $150,000 per annum in perpetuity.

                                                                                                            (5+3=8 marks)

Part b.

What are the potential advantages and disadvantages to a company’s shareholders if the company increases the proportion of debt in its capital structure?

                                                                                                                     

Part c.

1. From the below figures of Collingwood Public Limited, calculate Weighted Average Cost of Capital (WACC) and annual cashflows required by its capital providers.

Interest rate, kd	0.10
Statutory company tax rate, tc	0.30
Proportion of tc claimed by shareholders, λ	0.60
Market value of debt, D	$20 000 000
Cost of equity capital, ke	0.20
Market value of equity, E	$20 000 000

 

2. What are the main difficulties in calculating cost of capital for diversified companies?

Answer 1

Pecking order theory is a theory of capital finance which provides basis for raising of capital for he company and tries to explain why a company prefer one source of capital over the other. The main reson is that the cost of capital increases with the increased degree of assymetric information.

Under this theory, managers at the first place should opt for retained earnings as the source of finance as they have the complete information about working of the company and its financials. The next prospect for capital is debt funding and the final resort is raising the new equity. Investors believe that the managers know that the firm is overvalued and are taking advantage of the over valuation, hence investors demand higher rate of return making equity funding costly.

This theory maintains that businesses adhere to the heirarchy of financing sources and give most weight to internal funding.

ii)

Amount of funds needed = $1 million

Amount of earnings per year = $150,000

A) if funded through all equity, return to shareholders = (150,000 / 1 million) * 100 = 15%

B) if funded 50% from equity and 50% from debt @ 12%

amount of interest paid on debt = 12% * 500,000 = $60,000

balance profit after deducting interest = 150,000 - 60,000 = 90,000

return to shareholders = (90,000/500,000) * 100 = 18%

C) if funded 25% from equity and 75% from debt @12%

Interest paid on debt = 12% * 750,000 = 90,000

balance profit after deducting interest = 150,000 - 90,000 = $60,000

return to shareholders = (60,000/250,000)*100 = 24%