Question

A.As the financial manager of Wilmore Company Limited, with a passion to boost employment creation through intraregional tourism in Ghana, you have acquired a land at Ho to put up an exquisite amusement park that features a number of attractions including games, pools, gardens, rides etc. The project will cost a total of GH₵100,000. The following cash flows are expected from the project. The beta of the project is 1.5 and the market return is 15%. The risk-free rate of return is 8%.

Year ₵

0 (100,000)

1 20,000

2 25,000

3 32,000

4 35,000

i.Using the CAPM approach, what is the cost of equity on this project?

[2 marks]

ii.Wilmore Company Limited is a levered entity with percentage of debt out of total capital being 40%. If the interest rate on a bank loan is 10%, the tax rate is 20%, and the cost of equity is as computed in (a), what will be the after tax cost of debt? [2 mark]

iii.What will be the weighted average cost of capital (WACC)? [2 mark]

iv.Using the WACC computed in (c), what will be the NPV of the investment? ` [3 marks]

v.Compute the IRR for the project? [3 marks]

vi.What will be your overall advice concerning viability of the project?

[2 marks]

B.Mr. Norman and Mr. Foster are both investors looking to buy financial assets. Mr. Norman prefers assets with the lowest prices while Mr. Foster prefers assets on the financial market with higher prices. Each of them currently has GHC 1,000 to invest and needs your assistance to know which asset to buy to suit their preference. The following information provides details of investment options.

a.Asset A is a bond with a coupon rate of 10% and pays semi-annual coupons. The par value is GHC 1,000, and the bond has 5 years to maturity. The yield to maturity is 11%.

b.Asset B is a stock whose dividend is expected to increase by 20% in one year and by 15% in two years. After that, dividends will increase at a rate of 5% per year indefinitely. The last dividend was GHC 100 and the required return is 20%.

Which asset will Mr. Norman and Mr. Foster invest in? [8 marks]

  

C.In the 2020 accounting year, investors made a number observations in terms of certain decisions some corporations were taking:

(i) The board of directors of some manufacturing and services companies decided to pay stock dividends instead of cash dividends;

(ii) On the other hand, the board of directors of majority of companies within the ICT industry decided to pay special cash dividends;

(iii) It was also observed that some the management of some companies had decided to repurchase shares while others were engaging in stock splits.

What could be the reason for these three decisions and choice of dividend payments by the boards of these companies and what will be the effect of such decisions on the outstanding number of shares

Answer 1

A.i)Calculation of cost of equity as per CAPM

Cosy of equity(Ke)=Risk free rate+Beta(Market rate of return-Risk free rate)

=8%+1.5(15%-8%)

=18.50%

ii)Calculation of after tax cost of debt(Kd)

Kd=Interest(1-tax rate)

=10%(1-0.20)=8%

iii)Calculation of WACC

Weight of debt(Wd)=40% or 0.40

Weight of equity(We)=(1-Weight of debt)

=1-0.40=0.60

WACC=Ke*We+Kd*Wd

=18.50%*0.60+8%*0.40

=14.30%

iv)Calculation of NPV

Discount rate=WACC=14.30%

NPV=Present value of cash inflows-Present value of cash outflows

Year	Cash flow(GH₵) (a)	Present value [email protected]% (b)	Present value(a*b)
0	(100,000)	1	(100,000)
1	20,000	0.875	17,500
2	25,000	0.765	19,125
3	32,000	0.670	21,440
4	35,000	0.586	20,510
Net Present value(NPV)	(21,425)

v)Calculation of IRR of the project

IRR is the rate at which NPV of the project is zero

Since the NPV at 14.30% is negative,hence IRR must be lower than 14.30%.Lets calculate the NPV at 2%

Year	Cash flow(GH₵) (a)	Present value factor@2% (b)	Present value(a*b)
0	(100,000)	1	(100,000)
1	20,000	0.980	19,600
2	25,000	0.961	24,025
3	32,000	0.942	30,144
4	35,000	0.924	32,340
Net Present value(NPV)	6,109

Since the NPV at 2% is positive, hence IRR must be between 2% and 14.30%.IRR shall be calculated as follows;

IRR=Lower rate+[NPV at lower rate/Present value of cash inflows at(Lower rate-Higher rate)]*Higher rate-lower rate]

=2%+[6,109/(106109-78,575)]*(14.30%-2%)

=2%+2.73%

=4.73%

vi)Since the NPV of the Project at WACC is negative and also IRR is lower than the WACC,hence the project is not viable.