Unit: Advanced Financial Management
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Login to Access| Company | Equity beta | Financed by: |
| X | 1.33 | 40% equity capital, 60% debt capital |
| Y | 0.78 | 75% equity capital, 25% debt capital |
| Z | 0.725 | 80% equity capital, 20% debt capital |
| Value of debt | Probability of financial distress | Pre-tax cost of debt (%) |
| Sh.“million” | ||
| 25 | 0.0000 | 7 |
| 50 | 0.0125 | 8 |
| 75 | 0.0250 | 9 |
| 100 | 0.0625 | 10 |
| 125 | 0.1250 | 11 |
| 150 | 0.3125 | 12 |
| 200 | 0.7500 | 13 |
| Sh.“000” | |
| Ordinary share capital (Par value Sh.375) | 187,500 |
| Reserves | 364,500 |
| Shareholder’s equity | 552,000 |
| Long-term liability: | |
| 14% debenture stock (Par value Sh.1,500) | 355,500 |
| Capital employed | 907,500 |
| Percentage (%) of debt (Debt/Debt + Equity) | Likely credit rating | Pre-tax cost of debt (%) |
| 10 | AAA | 6.5 |
| 20 | AA | 7.1 |
| 30 | A | 7.8 |
| 40 | BBB | 8.5 |
| 50 | BB | 10 |
| 60 | B | 12 |
| 70 | C | 15 |
| \(\displaystyle \text{β}_e = \text{β}_a \left[\frac{E + D(1 – t)}{E} \right]\) |
| Where: | \(\text{β}_e\)= Equity beta \(\text{β}_a\)= Asset beta D = Debt E = Equity t = Corporate tax rate |
| Sh.“000” | |
| Ordinary share capital (Sh.20 par value each) | 80,000 |
| Reserves | 20,000 |
| 16% debt (Sh.100 par value each) | 40,000 |
| 10% preference share capital (Sh.30 per value each) | 60,000 |
| 200,000 |
| Papa Ltd. Sh.“million” | Kaka Ltd. Sh.“million” | |
| Equity (market value) | 100 | 70 |
| 5% debt (trading at par) | - | 50 |
| Yield to maturity on debt | 8% |
| Market value of debt | Sh.100 million |
| Number of ordinary shares | 10 million |
| Market price per ordinary share | Sh.30 |
| Cost of capital if all equity financed | 10.3% |
| Marginal tax rate | 30% |
| 1. | Johnson Njogu, a financial analyst expects that an increase in Tembo Ltd’s financial leverage will increase its costs of debt and equity. |
| 2. | Based on an examination of similar companies in Tembo Ltd. industry, Johnson Njogu estimates that the company’s cost of debt and cost of equity at various debt to total capital ratios are as shown below: Estimates of Tembo Ltd. before tax costs of debt and equity: |
| Debt to total capital ratio (%) | Cost of debt (%) | Cost of equity (%) | |
| 20 | 7.7 | 12.5 | |
| 30 | 8.4 | 13.0 | |
| 40 | 9.3 | 14.0 | |
| 50 | 10.4 | 16.0 |
| 1. | The machine costs Sh.28,000,000 and it would have a useful life of five years with a trade in value of Sh.5,600,000 at the end of year five. |
| 2. | The company has two options: Option A Purchase the machine for cash using a bank facility. The current rate of interest is 15% before tax. Option B Lease the machine under an agreement which would entail payment of Sh.6,720,000 at the end of each year for the next five years. |
| 3. | The corporate rate of tax is 30%. |
| 4. | Capital allowance is given at the rate of 100% in year one if the machine is purchased. |
| 5. | Tax is payable one year in arrears. |
| (i) | 20% debt and 80% equity. |
| (ii) | 50% debt and 50% equity. Hamada Model \(\beta_L =\beta_U[1 + (1 -T)(D/E)]\) Where: \(\beta_L\)\(=\) Levered beta \(\beta_U\) \(=\) Unlevered beta T \(=\) Tax rate \(D/E =\) Debt to equity ratio |
| Sh. "000" | |
| Sales | 25,678 |
| Total assets | 49,579 |
| Total liabilities | 5,044 |
| Retained earnings | 1,770 |
| Net working capital | (1,777) |
| Earnings before interest and taxes | 2,605 |
| Market value of equity | 10,098 |
| Book value of total liabilities | 5,044 |
| Value of debt Sh. "million" | Probability of financial distress (%) | Pre-tax cost of debt (%) |
| 2.5 | 0.00 | 4 |
| 5.0 | 1.25 | 6 |
| 7.5 | 2.50 | 10 |
| 10.0 | 6.25 | 15 |
| 12.5 | 12.50 | 18 |
| 15.0 | 31.25 | 20 |
| 20.0 | 75.00 | 22 |
| Value of debt(Sh.m) | Probability of financial distress | Pre-tax cost of debt (%) |
| 2.5 5.0 7.5 10 12.5 15 20 | 0.00 0.0125 0.025 0.0625 0.125 0.3125 0.75 | 6 7.5 9 10 11.5 12.5 14 |
| Percentage debt (%) | Pre-tax cost of debt (%) |
| 10 20 30 40 50 60 70 | 6.5 7.1 7.8 8.5 10 12 15 |
| Sh. "000" | |
| Ordinary share capital (Sh.10 par value) | 80,000 |
| Reserves | 20,000 |
| 10% irredeemable debenture capital (Sh.100 par value) | 30,000 |
| 8% preference share capital (Sh.20 par value) | 20,000 |
| 150,000 |
| 1 | The current market price per share (MPS) of the firm's ordinary shares is Sh. 34.80 cum-dividend. |
| 2 | The firm adopts a 60% dividend payout ratio. |
| 3 | The most recent earnings per share (EPS) of the firm is Sh.8.00. |
| 4 | The historical dividend per share (DPS) over the last four years are given as follows: |
| Year | Dividend per share (DPS) (Sh.) | |
| 2015 2016 2017 2018 | 4.00 4.20 4.50 4.80 |
| 5 | The firm's management is contemplating to invest in a project which would cost Sh.40 million. The project is expected to generate Sh.9 million each year in perpetuity. |
| 6 | The project has an estimated beta of 1.50. |
| 7 | The return from a well diversified market portfolio is 18%. |
| 8 | The debentures are considered to be risk-free and are valued at par. |
| 9 | The existing 8% irredeemable preference shares are currently trading at Sh.25 each. |
| 10 | The corporation tax rate is 30%. |
| Sh. "000" | |
| Ordinary share capital (Sh.20 par value) | 50,000 |
| Reserves | 20,000 |
| 14% debenture capital | 20,000 |
| 10% preference share capital | 10,000 |
| 100,000 |
| 1 | The company is considering raising the funds using two alternative financing options namely: Option 1: To raise all the funds through the issue of new ordinary shares at par. Option II: To raise half ofthe funds through the issue of new ordinary shares at par and the balance through the issue of new 12% debentures at par. |
| 2 | The corporation tax rate is 30%. |
| Debt to equity ratio | Bond rating | Before tax cost of debt (%) |
| 0.00 0.25 0.60 1.70 2.50 | A BBB BB C D | 0 8.5 10 14 16 |
| Sh. "000" | |
| Ordinary share capital (Sh.50 par value) | 120,000 |
| Share premium | 40,000 |
| Retained earnings | 80,000 |
| Shareholders' funds | 240,000 |
| 1 | Financing option one: This is an all equity capital structure. Three million shillings would be raised by selling ordinary shares at Sh.40 per share. |
| 2 | Financing option two: This will involve the use of financial leverage. One million shillings would be raised by selling corporate bonds with an effective interest rate of 14 per cent per annum. The remaining Sh. 2 million would be raised by selling ordinary shares at Sh.40 per share. The use of financial leverage is considered to be a permanent part of the firm's capital so no fixed maturity date is needed for the analysis. |
| 3 | The corporation tax rate appropriate for this analysis is 30%. |
| Alpha Ltd. | BetaLtd. | |
| Number of ordinary shares outstanding | 90,000,000 | 150,000,000 |
| Market price per share | Sh.18 | Sh.10 |
| 6% debentures (market value) | Sh.60,000,000 | - |
| Profit before interest and tax | Sh.18,000,000 | Sh.18,000,000 |
| Sh."000" | |
| Ordinary shares (Sh.2.5 par value) | 5,000 |
| Reserves | 11,000 |
| 16,000 |