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The pecking order theory says that firms prefer internal financing (that is, earnings retained and
re invested) over external financing. If external financing is needed, they prefer to issue debt
rather than issue new shares. The pecking order theory starts with the observation that managers
know more than outside investors about the firm’s value and prospects. Therefore, investors find
it difficult to value new security issues, particularly issues of common stock. Internal financing
avoids problem. If external financing is necessary, debt is the first the choice. The pecking order
theory says that the amount of debt a firm issues will depend on its need for external financing.
The theory also suggests that financial managers should try to maintain it at least some financial
slack, that is, a reserve of ready cash or unused borrowing capacity.
Kavungya answered the question on April 13, 2022 at 12:07
- Kitunda Ltd. has estimated the cost of debt and equity for various financing gearing levels as follows:
Required:
(i) The optimal capital structure.
(ii) Kitunda Ltd. wishes to...(Solved)
Kitunda Ltd. has estimated the cost of debt and equity for various financing gearing levels as follows:
Required:
(i) The optimal capital structure.
(ii) Kitunda Ltd. wishes to transform from its optimal gearing level to all-equity financed firm.
Modigliani and Miller's model with no taxes to determine the equity cost of capital.
Date posted: April 13, 2022. Answers (1)
- The following information relates to Unified Holdings Ltd.'s capital structure, whose cost of debt varies according to its gearing level:
Additional information
1. Risk free rate is...(Solved)
The following information relates to Unified Holdings Ltd.'s capital structure, whose cost of debt varies according to its gearing level:
Additional information
1. Risk free rate is 8%.
2. Market return is 16%.
3. Corporate tax rate is 30%.
4. The company's ungeared beta (asset beta) is 0.95
Required;
Unified Holding Ltd’s optimal weighted average cost of capital (WACC).
Date posted: April 13, 2022. Answers (1)
- Describe the following methods of credit enhancement.
i) Excess spread.
ii) Overcollateralization.
iii) Surety bond.(Solved)
Describe the following methods of credit enhancement.
i) Excess spread.
ii) Overcollateralization.
iii) Surety bond.
Date posted: April 13, 2022. Answers (1)
- Millennium Investments Ltd. wishes to raise funds amounting to Sh.10 million to finance a project in the following manner:
Sh.6 million from debt; and Sh.4 million...(Solved)
Millennium Investments Ltd. wishes to raise funds amounting to Sh.10 million to finance a project in the following manner:
Sh.6 million from debt; and Sh.4 million from floating new ordinary shares.
The present capital structure of the company is made up as follows:
1) 600,000 fully paid ordinary shares of Sh.10 each
2) Retained earnings of Sh.4 million
3) 200,000, 10% preference shares of Sh.20 each.
4) 40,000 6% long term debentures of Sh.150 each.
The current market value of the company’s ordinary shares is Sh.60 per share. The expected ordinary share dividends in a year’s time is Sh.2.40 per share. The average growth rate in both dividends and earnings has been 10% over the past ten years and this growth rate is expected to be maintained in the foreseeable future.
The company’s long term debentures currently change hands for Sh.100 each. The debentures will mature in 100 years. The preference shares were issued four years ago and still change hands at face value.
Required:
(i) Compute the component cost of:
Ordinary share capital;
- Debt capital
- Preference share capital
(ii) Compute the company’s current weighted average cost of capital.
(iii) Compute the company’s marginal cost of capital if it raised the additional Sh.10 million as envisaged. (Assume a tax rate of 30%).
Date posted: April 13, 2022. Answers (1)
- On 1 November 2002, Malaba Limited was in the process of raising funds to undertake four investment projects. These projects required a total of Sh.20...(Solved)
On 1 November 2002, Malaba Limited was in the process of raising funds to undertake four investment projects. These projects required a total of Sh.20 million.
Given below are details in respect of the projects:
Required:
(i) The levels of total new financing at which breaks occur in the Weighted Marginal Cost of Capital (WMCC) curve.
(ii) The weighted marginal cost of capital for each of the 3 ranges of levels of total financing as determined in (i) above.
(iii) Advise Malaba Limited on the projects to undertake assuming that the projects are not divisible.
Date posted: April 13, 2022. Answers (1)
- Explain the term “agency costs” and give any three types of such costs.(Solved)
Explain the term “agency costs” and give any three types of such costs.
Date posted: April 13, 2022. Answers (1)
- Biashara Ltd, has the following capital structure
The finance manager of Biashara Ltd. has a proposal for a project requiring Sh.45 million. He has
proposed the following...(Solved)
Biashara Ltd, has the following capital structure
The finance manager of Biashara Ltd. has a proposal for a project requiring Sh.45 million. He has
proposed the following method of raising the funds.
• Utilise all the existing retained earning.
• Issue ordinary share at the current market price.
• Issue 100,000 10% preference shares at the current market price of Sh.100 per share which
is the same as par value.
• Issue 10% debentures at the current market price of Sh.1,000 per debenture
Additional Information:
1. Currently Biashara Ltd. Pays a dividend of Sh5 per share which is expected to grow at the rate of
6% due to increased returns from the intended project. Biashara Ltd.’s. price/earnings (P/E) ratio
and earnings per share (EPS) are Sh5 and Sh.8 respectively.
2. The ordinary share would be issued at a floatation cost of 10% based on the market price
3. The debenture par value is Sh.1,000 per debenture
4. The corporate tax rate is 30%
Required:
Biashara Ltd.’s weighted average cost of capital (WACC)
Date posted: April 13, 2022. Answers (1)
- Zatex ltd, had the following capital structure as at 31 March 2005
Additional Information;-
1. The market price of each of ordinary share as at 31 March...(Solved)
Zatex ltd, had the following capital structure as at 31 March 2005
Additional Information;-
1. The market price of each of ordinary share as at 31 March 2005 was Sh.20
2. The company paid a dividend of Sh.2 for each ordinary share for the year ended 31 March 2005
3. The annual growth rate in dividends is 7%
4. The corporation tax rate is 30%
Required:
i) Compute the weighted average cost of capital of the company as at 31 March 2005.
ii) The company intends to issue a 15% Sh.2 million debenture during the year ending 31 March
2006. The existing debentures will not be affected by this issue. The dividend per share for the
year ending 31 March 2006 is expected to be Sh.3 While the average market price per share
over the same period is estimated to be Sh.15. The average annual growth rate in dividend is
expected to remain at 7%.
Compute the expected weighted average cost of capital as at 31 March 2006.
Date posted: April 13, 2022. Answers (1)
- The following information was extracted from the books of Faida Limited as at 31 December Required:
i. Cost of ordinary share capital.
ii. Cost of 8% preference...(Solved)
The following information was extracted from the books of Faida Limited as at 31 December Required:
i. Cost of ordinary share capital.
ii. Cost of 8% preference share capital.
iii. Cost of 10% preference share capital.
iv. Cost of 10% debentures.
v. Market –weighted average cost of capital2005.
Date posted: April 13, 2022. Answers (1)
- Explain the advantages of using market value weights over book value weights in computing the weighted average cost of capital.(Solved)
Explain the advantages of using market value weights over book value weights in computing the weighted average cost of capital.
Date posted: April 13, 2022. Answers (1)
- Mount Elgon Ltd. is considering the launch of a new product. Exel, for which an investment of Sh.6,000,000 in plant and machinery will be required....(Solved)
Mount Elgon Ltd. is considering the launch of a new product. Exel, for which an investment of Sh.6,000,000 in plant and machinery will be required. The production of Exel is expected to last five years after which the plant and machinery would be sold for Sh. 1,500,000.
Additional Information:
1) Exel would be sold at Sh.600 per unit with a variable cost of Sh240 per unit
2) Fixed production costs (excluding depreciation) would amount to Sh.600,000 per annum
3) The Company applies the straight line method of depreciation
4) The cost of capital is 10% per annum
5) The units of Exel expected to be sold per annum for the next five years as shown below
Year: Units expected to be sold
1 : 8,000
2 : 7,000
3 : 7,000
4 : 5,000
5 : 3,000
6) The corporation tax rate is 30%
Required:
i. Calculate the net present value (NPV) of the project and advise the management on the
appropriate course of action.
ii. Calculate the internal rate of return (IRR) of the project and advise the management on the
appropriate course of action.
iii. Outline the main drawbacks of the IRR method of investment.
Date posted: April 13, 2022. Answers (1)
- Distinguish between compounding and discounting of cash flows.(Solved)
Distinguish between compounding and discounting of cash flows.
Date posted: April 13, 2022. Answers (1)
- Upendo Ltd. is in the process of raising additional finance. The company’s financial structure
comprises ordinary share capital, reference share capital, debenture capital and retained earnings.
Each...(Solved)
Upendo Ltd. is in the process of raising additional finance. The company’s financial structure
comprises ordinary share capital, reference share capital, debenture capital and retained earnings.
Each of these sources of finance is analyzed below:
Ordinary Share Capital
• The current market price per share is Sh.80
• The company expects to pay a cash dividend of Sh.6 per share in the next financial year
• The annual rate of growth in dividend per share is 6%
• Flotation costs amounting to Sh8 per share
11% Preference Share Capital
• The par value per share is Sh.100
• The share are currently trading at par
• Flotation costs amounting to Sh.4 per share 10% Debenture Capital
• The per value is Sh1,000 for each debenture stock
• The debenture have ten-year maturity period
• The flotation cost for each debenture stock is Sh.50 Retained Earnings
• The company expects to have Sh.225,000 of retained earnings available for the next financial year.
• Should the retained earnings balance to exhausted, the company will use common stock as the form of equity financing
Required:
i) Calculate the cost of Capital for ordinary share capital, preference share capital, debenture
capital and retained earnings
ii) Calculate the marginal cost of capital applying the target capital proportions and using
retained earnings to represent equity finance
iii) Comment on the relevance of the marginal cost of capital in (ii) above to Upendo Ltd.
Date posted: April 13, 2022. Answers (1)
- The following was the capital structure of Fahari Ltd. as at 31 October 2007.
Additional information:
1. The market prices per ordinary share, preference share and debenture...(Solved)
The following was the capital structure of Fahari Ltd. as at 31 October 2007.
Additional information:
1. The market prices per ordinary share, preference share and debenture were sh. 45, and sh. 30
and sh. 1,200 respectively on 31 October 2007.
2. The dividend per ordinary share for the year ended 31 October 2006 was sh. 8.00. Dividends
are expected to grow at an annual rate of 12 percent.
3. The rate of corporation tax is 30 per cent.
Required:
The weighted average cost of capital (WACC) of fahari Ltd. Use market value weights
Date posted: April 13, 2022. Answers (1)
- Jasmin Ltd. a quoted company intends to raise sh. 14,000,000 to finance a capital project. The company is considering issuing the following securities in order...(Solved)
Jasmin Ltd. a quoted company intends to raise sh. 14,000,000 to finance a capital project. The company is considering issuing the following securities in order to raise the required amount.
• 200,000 ordinary shares at the ex- div market price subject to a 10% floatation cost per share.
The company’s issued shares are currently trading at sh. 32.40 per share cum – div. Dividends for the year ended 31 December 2008 have not yet been paid to shareholders.
• 40,000 12% debentures at the current market price of sh. 80 per debenture. The par value of each debenture is sh. 100.
• 100,000 10% preference shares at the current par value of sh. 20 per share.
The balance of the capital required would be obtained from retained earnings.
Required:
i) Ex – div market price per ordinary share.
ii) Cost of capital for each component of additional finance.
iii) Marginal cost of capital of the company.
iv) Comment on the application of the marginal cost of capital obtained in b(iii) above.
Date posted: April 11, 2022. Answers (1)
- Karatasi Ltd. had the following capital structure as at 31 December 2008.
Additional information:
1. The current market price per ordinary share, preference share and debenture is...(Solved)
Karatasi Ltd. had the following capital structure as at 31 December 2008.
Additional information:
1. The current market price per ordinary share, preference share and debenture is sh.. 50, sh. 24 and sh. 1,200 respectively.
2. For the year ended 31 December 2008, the company paid an ordinary dividend of sh. 6.00 per share. Analysts estimate that the company’s earnings and dividends will grow at an annual rate of 15 per cent indefinitely.
3. The corporation tax rate is 30 per cent.
Required;-
The company’s market weighted average cost of capital.
Date posted: April 11, 2022. Answers (1)
- The capital structure of Jmaa Ltd. Which is considered optimal, as at 30 September 2009 was as follows :
The company intends to raise additional funds...(Solved)
The capital structure of Jmaa Ltd. Which is considered optimal, as at 30 September 2009 was as follows :
The company intends to raise additional funds for investing in a new project which is estimated to
cost sh. 240 million.
Additional information:
1. Any new ordinary shares issued will incur a 12% floatation cost per share.
2. The most recent ordinary dividend per share was sh. 5.
3. The past and expected future earnings growth rate is 10%. The earnings growth rate is expected
to be matched with growth rate in dividends.
4. The current dividend rate is 6.25%.
5. The company expects to raise a maximum of sh. 36 million from retained earnings to finance
the project.
6. Additional 8% preference shares can be issued at the current market price of sh. 80 per share.
7. A new 12% debenture can be issued at sh. 960 for each debenture through the stock exchange.
8. Corporation tax rate is 30%.
Required:
i) The current market price per ordinary share.
ii) The number of ordinary shares that should be issued to finance the project.
iii) The company’s weighted marginal cost of capital (WMCC)
Date posted: April 11, 2022. Answers (1)
- Pick Ltd has the following capital structure which is considered optimal. The investors of Pick ltd expect earnings and dividends to grow at a constant...(Solved)
Pick Ltd has the following capital structure which is considered optimal.
The investors of Pick ltd expect earnings and dividends to grow at a constant rate of 9% in the future.
The company has just paid a dividend of sh.3.6 per share and its stock currently sells at a price of sh.60 per share. Treasury bonds yield 11% and the return on the market is 14%.Pick ltd beta is 1.51 New preferred stock can be sold at sh.100per share with a dividend of sh.11 per share and flotation costs of sh.5 per share.
The company’s tax rate is 30%and it pays out all its earnings as dividend.12% debentures with a maturity of 10 years can be sold at sh.92 per debenture
Required
The weighted average cost of capital (WACC) using market values
Date posted: April 11, 2022. Answers (1)
- The optimal capital structure of DP Ltd. is as shown below.
The company has sh. 300,000 in retained earnings and is considering investing in a project...(Solved)
The optimal capital structure of DP Ltd. is as shown below.
The company has sh. 300,000 in retained earnings and is considering investing in a project which will cost sh. 1,200,000
Required:
i) The marginal cost of capital (MCC) assuming a 30% tax rate.
ii) Retained earnings break point.
Date posted: April 11, 2022. Answers (1)
- Explain the meaning of the term “enterprise value” in the context of the valuation of a business entity.(Solved)
Explain the meaning of the term “enterprise value” in the context of the valuation of a business entity.
Date posted: April 11, 2022. Answers (1)