Question

Question 2 Active PLC is a leading investment company in Australia and you the below details relating to the capital structure of the company. Information concerning raising new capital Bonds $1,000 Face value 13% Coupon Rate (Annual Payments) 20 Term (Years) $25 Discount offered (required) to sell new bonds $10 Flotation Cost per bond Preference Shares 11% Required rate to sell new preference shares $100 Face Value $3 Flotation cost per share Ordinary Shares $83.33 Current Market Price $4.00 Discount on share price to sell new shares $5.40 Flotation Cost per bond $5.00 2019 - Proposed Dividend Dividend History $4.63 2019 $4.29 2018 $3.97 2017 $3.68 2016 $3.40 2015 Current Capital Structure Extract from Balance Sheet $1,000,000 Long-Term Debt $800,000 Preference Shares $2,000,000 Ordinary Shares Current Market Values $2,000,000 Long-Term Debt $750,000 Preference Shares $4,000,000 Ordinary Shares Tax Rate 33% Risk Free Rate 5% 3 a) Calculate the cost associated with each new source of finance. The firm has no retained earnings available. b) Calculate the WACC given the existing weights The financial controller does not believe the existing capital structure weights are appropriate to minimise the firm’s cost of capital in the medium term and believes they should be as follows Long-term debt 40% Preference Shares 15% Ordinary Shares 45% c) What impact do these new weights have on the WACC? The firm is considering the following investment opportunity. (2020-2027) Data is as follows Initial Outlay $1,600,000 Upgrade $700,000 End of Year 4 Upgrade - 350,000 Increased sales units per annum - (Year 5-8) Working Capital $45,000 Increase required Estimated Life 8 Years Salvage Value $60,000 Depreciation Rate 0.125 For tax purposes The machine is fully depreciated by the end of its useful life Other Cash Expenses $60,000.00 Per annum (Years 1-4) Other Cash Expenses $76,000.00 Per annum (Years 5-8) Production Costs $0.15 Per Unit Sales price $0.75 Per Unit (Years 1-4) Sales price $1.02 Per Unit (Years 5-8) 4 Prior sales estimates Year Sales 2010 520000 2011 530000 2012 540000 2013 560000 2014 565000 2015 590000 2016 600000 2017 610000 2018 615559 2019 659000 2020 680000 d) Calculate the Net Present Value, Internal Rate of Return and Payback Period The financial controller is considering the use of the Capital Asset Pricing Model as a surrogate discount factor. The risk-free rate is 5 per cent. Year Stock Market Share Index Price 2010 2000 $15.00 2011 2400 $25.00 2012 2900 $33.00 2013 3500 $40.00 2014 4200 $45.00 2015 5000 $55.00 2016 5900 $62.00 2017 6000 $68.00 2018 6100 $74.00 2019 6200 $80.00 2020 6300 $83.33 e) Calculate the CAPM f) Explain why this figure may differ from that calculated above (i.e. Cost of equity – Ordinary Shares)

Answer 1

Answer:

Question 1:

Wealth maximization overcomes the short-comings of profit maximization. The stand-alone principle says to only consider incremental cashflows while deciding on a project. Only incremental cash flows are taken into consideration for project evaluation.

Question 2:

(a)   Cost of Bond = 9.10%, Cost of Preference Shares = 11.34%, Cost of ordinary Shares = 14.76%

(b)   WACC =12.70%

(c)    WACC = 11.98%

(d)   NPV = $47,510, IRR = 12.65%, Payback Period = 5.87 Years

(e)   10.76%

(f)     Because different methods of calculation are used

Question 3:

(a)   $146.4

(b)   Debt Required = $108, Equity Required = $38.40

(c)    $46.40

Question 4:

(a)   $30.40

(b)   $9.6

(c)    16%

(d)   $67.20

(e)   7.84%

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Step By Step Explanation:

Question 1:

The objective of profit maximization is very narrow, it only considers the profit reported and fails to report on the conditions & health of the company like business risk, economic risk, etc. Earnings of a company are easy to manipulate like through change in depreciation charged or by the exploitation of workers, etc. When profit maximization becomes the sole objective of the company, the management starts using unfair means to achieve the highest possible profits. While wealth maximization is calculated by the market value (MV) of the security and the market value (MV) of the security is decided by the market forces which consider all the above-mentioned shortcomings. Wealth maximization is calculated using the concept of cash outflows & inflows which cannot be manipulated.

The stand-alone principle says that instead of analyzing the total cash flows of the project, the decision should be taken by only considering the incremental cash flows. Only incremental cash flows are taken into consideration for project evaluation.

Question 2:

(a)

Formulas used are:

(b), (c)

Formulas used are:

(d)

Formulas used are:

(e)

Formulas used are:

(f)

There is a difference between the cost of equity (R_e) calculated in part (e) & (a) because the methods used are different. In part (a), the GGM (Gordon growth model) has been used to calculate the R_e which considers that the R_e is dependent on the current MV (market value), dividend growth rate of the company & current dividend. While CAPM considers that the R_e also depends on other returns like market return, risk-free return, and also the systematic risk of the security interpreted through its beta. These differences are the cause of the difference in the R_e calculated.

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Question 3

Formulas used are:

Question 4:

Additional Funds Needed = (A₀ x (ΔS / S₀)) - (L₀ x (ΔS / S₀)) - (S₁ x PM x b)

Where,

A₀ = Current total assets

L₀ = Current total liabilities

ΔS/S₀ = % increase in sales

S₁ = Sales after increase

PM = Profit Margin

b = Retention rate

Note: We will take L₀ = 0 because we are calculation total external funds needed which include long-term debt, only change in current liability will be considered which is 0.

Sustainable Growth Rate = ROE × Retention Rate

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Calculations:

Formulas used are:

Part (e)

0 = ($1,100 x g) - (0 x g) - (($1,100 x (1 + g)) x (210/1100) x (1 - 80/210))

g = 7.84%