QUESTION ONE Sebenzani plc is a quoted company. Its directors are reviewing the company's long term investment financing strategy. The company has been criticised for being financed largely by equity. It has no significant long term borrowings. The board has asked for some calculations to enable them to decide whether the company should consider borrowing in the future. The next phase of expansion will require the company to raise K200m and will involve a general expansion of the existing lines of business. The following information has been obtained: Current risk free rate 4% Equity risk premium 5% Current corporation tax rate 30% Equity capital K1,000m Sebenzani plc's Beta 1.4 Probable gross interest rate on debt 7% Required A. Calculate Sebenzani plc's expected weighted average cost of capital (WACC). (5 Marks) B. Calculate Sebenzani plc's expected WACC after the new finance has been raised assuming that the finance is raised by borrowing. (10 Marks) C. Explain the concept of CAPM in relation to cost of capital and risk in investment. (5 Marks) D. It has been suggested that company directors are often motivated by a desire to act in their own best interests rather than those of the shareholders. Explain why directors might be reluctant to use the capital asset pricing model (CAPM) as a decision making criterion for financial planning. (5 Marks)
Added by Jared Z.
Close
Step 1
Calculate Sebenzani plc's expected weighted average cost of capital (WACC). ** Show more…
Show all steps
Your feedback will help us improve your experience
Anand Jangid and 76 other Principles of Accounting educators are ready to help you.
Ask a new question
Labs
Want to see this concept in action?
Explore this concept interactively to see how it behaves as you change inputs.
Recommended Videos
Akash M.
NewEra Ltd is a firm in the auto sector with $750 million of equity and $500 million of debt in its capital structure (market values). It has 60 million shares outstanding with a 15% unlevered cost of capital and 4% risk-free interest rate on its debt. The corporate tax rate is 30%. The firm initially proposes to fund the new project by issuing equity. If investors were not expecting this investment, and if they share the firm's view of the project's profitability, what will the share price be once the firm announces the project plan? Suppose investors think that the EBIT from the firm's new project will be only $45 million per year without any growth (i.e., $45 million every year to perpetuity). What will the share price be in this case? How many shares will the firm need to issue? Suppose the firm issues equity as in part (b). Shortly after the issue, new information emerges that convinces investors that management was, in fact, correct regarding the cash flows from the new project. What will the share price be now? Why does it differ from that found in part (a)? How much will the old and new shareholders gain after the new information arrives? Suppose the firm instead finances the expansion with a $300 million issue of permanent risk-free debt. If the firm undertakes the expansion using debt, what is its new share price once the new information comes out?
The Finance Manager of Royal Myanmar Company believes that the cost of capital of a firm influences firm value and that it is very much related to the capital structure policy of a firm. The capital structure of a firm consists of debt and equity. To determine the cost of capital of the firm, he has collected the following information: • The firm's capital structure comprises of 30 percent debt and 70 percent equity. • The firm has bonds outstanding with 20 years to maturity; 12 percent annual coupon rate; face value of $ 1,000; and the current bond price is $ 1,252. • The firm uses Capital Asset Pricing Model (CAPM) to compute the cost of equity with the risk free rate at 2.5 per cent per annum, stock beta of 1.6 and market return of 12% per annum. • The firm pays tax at a rate of 30 per cent. Required: a) Determine the firm's after-tax cost of debt. Why is the after-tax cost of debt used in the Computation of cost of debt and not the before-tax cost? b) Compute the firm's cost of equity and its weighted average cost of capital (WACC)
Recommended Textbooks
Horngren’s Cost Accounting
Cost Accounting A Managerial Emphasis
Principles of Accounting Volume 1: Financial Accounting
Transcript
Watch the video solution with this free unlock.
EMAIL
PASSWORD