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Investors seek higher returns to compensate them for bearing higher risks. The required return would be a risk-free rate plus a risk premium to compensate the investors for the opportunity cost of not invested in the risk free investments such as treasury bills.
The higher the risks perceived by the investor, the higher the premium he will demand to invest in a particular investment.
Kavungya answered the question on April 25, 2022 at 09:55
- The following data relate to price and related financial details of three ordinary shares for the year 2012.
Required:
i) Total expected return for each of the...(Solved)
The following data relate to price and related financial details of three ordinary shares for the year 2012.
Required:
i) Total expected return for each of the three ordinary shares.
ii) Relative return for each of the three ordinary shares.
Assuming an investor combines all the three ordinary shares X, Y, Z in a portfolio in the ratio of 4:2:4 respectively. Determine the expected return of the portfolio.
Date posted: April 25, 2022. Answers (1)
- The following information relates to two potential investments namely; A and B.
Required:
The standard deviation of each of the two investments.(Solved)
The following information relates to two potential investments namely; A and B.
Required:
The standard deviation of each of the two investments.
Date posted: April 25, 2022. Answers (1)
- Musa Onyango has invested in a portfolio that comprises two assets as shown below;-
Correlation coefficient between the rates of return of asset “C” and asset...(Solved)
Musa Onyango has invested in a portfolio that comprises two assets as shown below;-
Correlation coefficient between the rates of return of asset “C” and asset “S” is 0.30
Required;-
i. Portfolio expected return
ii. Portfolio risk
Date posted: April 25, 2022. Answers (1)
- Using a well-labelled diagram, differentiate between ‘systematic risk’ and ‘unsystematic risk’.(Solved)
Using a well-labelled diagram, differentiate between ‘systematic risk’ and ‘unsystematic risk’.
Date posted: April 25, 2022. Answers (1)
- Two firms. A Ltd. And B Ltd. Operate in the same industry. The two firms are similar in all aspects except for their capital structures.
The...(Solved)
Two firms. A Ltd. And B Ltd. Operate in the same industry. The two firms are similar in all aspects except for their capital structures.
The following additional information is available.
i) A ltd. Is financed using sh.100 million worth of ordinary shares.
ii) B ltd. Is financed using sh.50 million in ordinary share and sh.50 million in 7% debentures.
iii) The annual earnings before interest and tax sh.10 million for both firms. These earning are expected to remain constant indefinitely.
iv) The cost of equity in A LTD.IS 10%.
v) The corporate tax rate is 30%.
Required:
Using the Modigliani miller (mm) model, determine the following.
i) The market value of A ltd. and B ltd.
ii) The weighted average cost of capital of A ltd. And B ltd.
Date posted: April 14, 2022. Answers (1)
- Biashara Ltd is financed by debt and equity. The company is in the process of determining the optimal capital structure that will minimize its weight...(Solved)
Biashara Ltd is financed by debt and equity. The company is in the process of determining the optimal capital structure that will minimize its weight average cost of capital.
The cost of debt at various levels of leverage is as follows:
Date posted: April 14, 2022. Answers (1)
- The following balance sheet relates to Mapeo Ltd for the year ending 31 December 2006:
Additional information:
i) The company’s earnings before interest and tax average sh.16,...(Solved)
The following balance sheet relates to Mapeo Ltd for the year ending 31 December 2006:
Additional information:
i) The company’s earnings before interest and tax average sh.16, 000,000 per annum
ii) The current market price per share is sh.90
iii) The corporate tax rate is 30%
iv) All the company’s profit are distributed as dividends
v) Assuming that all the assumptions of the traditional theory of capital structure hold, except for the existence of taxes
Required:
The company’s market-weight average cost of capital using the traditional theory
Date posted: April 14, 2022. Answers (1)
- Maisha Ltd and Bora Ltd manufacture wall clocks. The selling price of each clock is sh.1000 with a variable cost of sh.700.Each of the company...(Solved)
Maisha Ltd and Bora Ltd manufacture wall clocks. The selling price of each clock is sh.1000 with a variable cost of sh.700.Each of the company realizes average annual sales of sh.70,000,000 and incurs average fixed costs of sh.1,700,000 per annum.
Maisha Ltd and Bora Ltd manufacture wall clocks. The selling price of each clock is sh.1000 with a variable cost of sh.700.Each of the company realizes average annual sales of sh.70,000,000 and incurs average fixed costs of sh.1,700,000 per annum.
However, the two companies differ in their capital structures as stated below:
Maisha Ltd. Is an all-equity financed company having issued 40,000 ordinary shares of sh.10 per value.
Bora Ltd is financed with 20,000 ordinary shares of sh.10 per value and a loan of sh.1600, 000 at an interest rate of 10% per annum
The corporation tax is 30%
Required:
i) The of operating leverage and financial leverage for each company
ii) The degree of combine leverage for each company
iii) The break-even point (in units) for each company. Comment on the significance of your results
iv) The earning per share (EPS) at the point of indifference between the earning of the two
companies
Date posted: April 14, 2022. Answers (1)
- Dawanox Ltd, an unlevered firm, generates average earnings before interest and tax (EBIT) of Sh. 20 million per annum.the market value of the company as...(Solved)
Dawanox Ltd, an unlevered firm, generates average earnings before interest and tax (EBIT) of Sh. 20 million per annum.the market value of the company as at 31 October 2007, the company’s financial year-end, was Sh.120 million.
Required:
(i) The company’s cost of equity and weight average cost of capital(WACC) as at 31 October 2007
(ii) The company’s optimal level of debt finance using the Modigliani and Miller (MM) with-tax model (excluding financial distress costs)
(iii) The company’s optimal level of debt finance using the MM with-tax model incorporating financial distress costs.
Date posted: April 14, 2022. Answers (1)
- The following information relates to two firms; Bora Ltd and Beta Ltd:
Required:
i) Degree of operating leverage for each firm.
ii) Comment on how the operating leverage...(Solved)
The following information relates to two firms; Bora Ltd and Beta Ltd:
Required:
i) Degree of operating leverage for each firm.
ii) Comment on how the operating leverage has impacted on the earnings available to
shareholders of each firm
Date posted: April 14, 2022. Answers (1)
- The following information relates to Abacus Ltd, an all equity financed company
1 The market value of a company (determine using the net income approach)...(Solved)
The following information relates to Abacus Ltd, an all equity financed company
1 The market value of a company (determine using the net income approach) is sh. 130 million
2 The cost of equity is 16 per cent
3 The management of the company intends to replace sh. 8 million worth of equity with debenture of similar value (assume all legal requirement will be fulfilled).The cost of the debenture would be 12 per cent(before tax)
4 The company’s earnings before interest and tax (EBIT) are expected to remain constant in the foreseeable future
5 All earnings after tax are paid out as dividends
6 The corporate rate of tax is 30 per cent
Required:
(i) Using the Modigliani and Miller (MM) approach, assess the effects of the change in capital
structure on the market value of the company, cost of equity and weight average cost of capital.
(ii) Advise the management of the company on whether to change the capital structure
Date posted: April 14, 2022. Answers (1)
- The following extract of the balance sheet of Mapato Ltd, shows the capital structure of the company as at 31 December 2007
The management of the...(Solved)
The following extract of the balance sheet of Mapato Ltd, shows the capital structure of the company as at 31 December 2007
The management of the company considers the above capital structure to be optimal
Additional information:
1. The company’s earnings before interest and tax (EBIT) average sh 75 million per annum.
These are expected to be maintained in the foreseeable future
2. the ordinary shares are currently trading at Sh 4oo per share
3. the market price of the debentures is sh525 per debenture
4. The corporate rate of tax is 30 per cent
Required:
Using the net income approach (incorporate taxes), calculate the company’s
(i) Cost of Equity
(ii) After tax cost of debt(Market value weighted)
(iii) Market-weighted average cost of capital
Date posted: April 14, 2022. Answers (1)
- Hisa Ltd. has the following capital structure, which it considers optimal.
Additional information:
1. Hisa Ltd.'s expected profit after tax for the year ending 31 December 2008...(Solved)
Hisa Ltd. has the following capital structure, which it considers optimal.
Additional information:
1. Hisa Ltd.'s expected profit after tax for the year ending 31 December 2008 is Sh. 34,285,714.
Hisa Ltd. has an established dividend pay-out ratio of 30%. The tax rate for the company is 30%, and investors expect earnings and dividends to grow at a constant rate of 9% per annum in the future.
2. The company paid a dividend of Sh. 3.60 per share in the year ended 31 December 2007. The
company's shares currently sell at Sh. 60 per share.
3. The company can obtain new capital as follows:
Ordinary shares: New ordinary share capital can be issued at a floatation cost of 10%
Preference share capital: New preference share capital with a dividend of Sh. 11 per share can be
issued the public at Sh. 100 per share. The floatation cost is Sh. 5 per share.
Debentures: Debentures can be issued at an interest rate of 12% per annum.
4. Assume that the cost of capital is constant beyond the retained earnings break point.
Required:
i) Calculate the break point in the marginal cost of capital (MCC) schedule.
ii) Determine the cost of each capital structure component.
iii) Calculate the weighted average cost of capital (WACC) in the intervals between the break point in
the marginal cost of capital (MCC) schedule.
iv) Hisa Ltd. has the following investment opportunities:
Which of these projects should the company accept and why?
Date posted: April 14, 2022. Answers (1)
- Mapema Ltd has the following capital structure which it considers optimal:
Mapema Ltd expects an after tax income of sh.5143000 in the next financial year. The...(Solved)
Mapema Ltd has the following capital structure which it considers optimal:
Mapema Ltd expects an after tax income of sh.5143000 in the next financial year. The company has a policy of paying out 30% of its earnings as dividends. Investors expect dividends to grow at an annual rate of 9% indefinitely. The dividend last paid by the company was sh.5.40 per share. The company’s ordinary shares currently sell on the stock market at sh.90 per share .The Company can obtain additional financing in the financial markets as follows:
Long-term debt
Up to sh.7.5 million of long-term debt can be obtained at an interest rate of 12%: long-term debt in the
range of sh. 7.5 million to sh. 15 million must carry an interest rate of 14% and all long-term debt
over sh.15 million will have an interest rate of 16%. The corporate tax rate is 30% and interest on
long-term debt is tax allowable.
Ordinary shares
New ordinary shares of up to sh.18 million can be raised at sh.81 per share. To issue additional shares
above sh. 18 million floatation cost of sh. 18 per share must be incurred.
Preference shares
New preference shares with a par value of sh. 100 can be issued and the dividend rate is 11%.
However, a floatation cost of 5% of the par value per share must be incurred for all preference shares
up to sh.11.25 million. Additional preference shares (above sh.11.25 million) can be raised at a
floatation cost of shs.10 per share.
The investment opportunities available to the company are as shown below:
Required:
a) Determine the break points in the marginal cost of capital (MCC) schedule.
b) Calculate the weighted average cost of capital (WACC) in the intervals between the break points in the MCC schedule.
c) Calculate the internal rate of return (IRR) for project V.
d) Construct an investment opportunity curve (IOC)/ marginal cost of capital (MCC) schedule and indicate which project(s) should be accepted or rejected.
Date posted: April 13, 2022. Answers (1)
- The management of Shujaa Ltd is excited that the government has reduced the corporate tax rate from 33% to 30%. This tax cut is expected...(Solved)
The management of Shujaa Ltd is excited that the government has reduced the corporate tax rate from 33% to 30%. This tax cut is expected to increase the net present value of operating cash flows of the company by sh.15 million.
The current capital structure of the company is as follows:
The company’s shares are currently selling at sh.32.00 ex-div and the debentures are selling at sh. 135 cum-interest.
The equity beta is 1.2. The market return is 13%. Debt capital is risk free.
Assume that the cost of debt and the market price of the debentures will not change as a result of tax cut.
Required:
i) Determine Shujaa Ltd’s weighted average cost of capital (WACC) before the tax cut.
ii) Determine the expected market price per share of Shujaa Ltd after the tax reduction.
(In answering part (ii) above, use the Modigliani and Miller’s (MM) hypothesis under corporate taxes)
Date posted: April 13, 2022. Answers (1)
- Pentel Ltd, a computer assembly company, intends to expand its operations. This will require an expansion of its assets by 50%. The annual incremental sales...(Solved)
Pentel Ltd, a computer assembly company, intends to expand its operations. This will require an expansion of its assets by 50%. The annual incremental sales to be generated by this expansion are estimated to be sh. 18 million with annual incremental earnings before interest and taxes (EBIT) of 25% on incremental sales. All the financing for this expansion will come from external sources as profit retentions are already committed elsewhere.
A financial analyst hired by the company has submitted the following proposals of financing the expansion for consideration:
The tax rate is expected to remain constant at 30%.
Required:
a) The number of additional ordinary shares to be issued under financial plans B and C.
b) The earnings per share (EPS) indifference points between:
i) Plan A and plan B
ii) Plan A and plan C
iii) Plan B and plan C
c) Assume that the price/earnings (P/E) ratio will be 8 if plan C is adopted but will drop to 6 if either plan A or plan B is used to finance the expansion.
Determine the market price per share under each financing plan and advise Pentel Ltd, on the best means of financing the expansion.
Date posted: April 13, 2022. Answers (1)
- The finance manager of STN Ltd is planning new year’s capital budget. STN ltd expects its net income to be Sh 2,700,000 next year and...(Solved)
The finance manager of STN Ltd is planning new year’s capital budget. STN ltd expects its net income to be Sh 2,700,000 next year and its current dividend payout ratio is 30%. The company’s earnings and dividends are expected to grow at a constant rate of 8% per annum.
The last divided paid by the company was Sh 1.00 per share and the current equilibrium share price is Sh 16 STN Ltd can raise up to Sh 1,800,000 of debt at 11% before tax cost, the next Sh 1,800,000 will cost 12% and all debt above Sh 3,600,000 will cost13%. If STN Ltd issues new ordinary shares, a 12% underwriting cost will be incurred. STN Ltd can sell the first Sh 200,000 of new ordinary shares at the current market price, but to sell any additional new shares, STN Ltd must lower the price to Sh 14. STN Ltd is at its optimal capital structure, which is 60% debt and 40% equity and the firm’s corporation tax rate is 40%. STN Ltd has the following independent, indivisible and equally risky investment opportunities.
Required
a) The break points in the marginal cost of capital (MCC) schedule.
b) The cost of each component of the capital structure.
c) The weighted average cost of capital (WACC) in the interval between each break in the MCC schedule.
d) The MCC/IOS graph clearly indicating the projects to be undertaken.
e) STN Ltd’s optimum capital budget.
Date posted: April 13, 2022. Answers (1)
- Baba Ltd and Toto Ltd are firms operating in the same industry and are considered to be in the same risk class. Each firm has...(Solved)
Baba Ltd and Toto Ltd are firms operating in the same industry and are considered to be in the same risk class. Each firm has an operating profit of sh. 250,000,000 per annum. The capital structures of the firms are as follows:
The two companies have a 100% dividend payout ratio.
Required:
i) The weighted average cost of capital (WACC) of each of the two firms
ii) Comment of the equilibrium position of the equity shares, of the two firms.
iii) Advise Alusa, who holds 4% of Toto Ltd’s equity shares, on the arbitrage opportunities available to him (ignore taxation).
Date posted: April 13, 2022. Answers (1)
- Furnace Ltd wishes to evaluate two plans, leasing and borrowing to purchase an oven. The firm’s tax rate is 40%.
Lease option: The company can lease...(Solved)
Furnace Ltd wishes to evaluate two plans, leasing and borrowing to purchase an oven. The firm’s tax rate is 40%.
Lease option: The company can lease the oven under a 5 year lease requiring annual end-of year payments of Sh 5,000,000. All maintenance costs will be paid by the lease, while insurance and other costs will be borne by the lessee. The lessee will exercise its option to purchase the asset for Sh 4,000,000 at termination of the lease.
Purchase option: the oven costs Sh 20,000,000 and will have a five year useful life. Depreciation charges in the five years will be as follows: Year 1 Sh 4,000,000 Year 2 Sh 6,400,000, Year 3 Sh 3,800,000, Year 4 Sh 2,400,000 and Year 5 Sh 2,400,000. (The balance of value being the residual value).
The total purchase price will be financed by a 5 year, 15% loan requiring equal annual end of year payments of Sh 5,967,000. The firm will pay Sh 1 Million per year for a service contract that covers all maintenance costs. Insurance and other costs will be borne by the firm. The firm plans to keep the equipment and use it beyond its 5 year recovery period.
Required;
a) For the leasing option, calculate the following:
i) The after tax cash outflow each year.
ii) The present value of the cash flow, using a 9% discount rate.
b) In respect of the purchase options, calculate the following.
i) The annual interest expenses deductibles for tax purposes for each of the 5 years.
ii) The after-tax cash outflow resulting from the purchase for each of the 5 years
iii) The present value of the cash outflow, using a discount rate of 9%
c) Compare the present value of the cash outflow streams for the two plans and determine which
plan would be preferable.
Date posted: April 13, 2022. Answers (1)
- Explain the meaning of the “pecking order theory”.(Solved)
Explain the meaning of the “pecking order theory”.
Date posted: April 13, 2022. Answers (1)