Cost of capital
- This is the rate used to discount the future cash flows of a business, to
determine the value of the firm. The cost of capital can be viewed as the
minimum return required by investors and should be used when evaluating
investment proposals.
-In order to maximize the wealth of shareholders, the basic decision rule is that
if cash flows relating to an investment proposal are negative, the proposal
should be rejected. However, if the discounted cash flows are positive, the
proposal should be accepted. The discounting is carried out using the
firm's cost of capital.
Why cost capital should be calculated with care:
- Failure to calculate the cost of capital correctly can in incorrect investment
decisions being made.
- Where the cost of capital is understated, investment proposals which should be
rejected may be accepted.
- Similarly, where the cost of capital is overstated, investment proposals may be
rejected which should be accepted. In both cases, the shareholders would suffer
a loss.
Note There is an inverse relationship between N.P.V. and cost of capital. The higher the
cost of capital, the lower the N.P.V. and vice versa.
marto answered the question on February 11, 2019 at 10:37
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Date posted: February 11, 2019. Answers (1)
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Swaleh Ltd. has been in operation for the last eight years. The company is all equity
financed with 6 million ordinary shares with a par value of Sh.5 each. The current
market price per share is Sh.8.40, which is in line with the price/earnings (P/E) ratio in
the industry of 6.00. The company has been consistent in paying a dividend of Sh.1.25
per share during the last five years of its operations, and indications are that the current
level of operating income can be maintained in the foreseeable future. Tax has been at a
rate of 30%.
The management of Swaleh Ltd. is contemplating the implementation of a new project
which requires Sh.10 million. Since no internal sources of funds are available,
management is to decide on two alternative sources of finance, namely:
Alternative A
To raise the Sh.10 million through a rights issue. Management is of the opinion that a
price of Sh.6.25 per share would be fair.
Alternative B
To obtain the Sh.10 million through a loan. Interest is to be paid at a rate of 12% per
annum on the total amount borrowed.
The project is expected to increase annual operating income by Sh.5.6 million in the
foreseeable future.
Irrespective of the alternative selected in financing the new project, corporation tax is
expected to remain at 30%.
Required:
(i) Determine the current level of earnings per share (EPS) and the operating
income of the company.
(ii) If Alternative A is selected, determine the number of shares in the rights issue
and the theoretical ex-rights price.
(iii) Calculate the expected earnings per share (EPS) for each alternative, and advise
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Date posted: February 11, 2019. Answers (1)
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Project A
This project is made up of two sub-projects. The first sub-project will require an initial
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have a residual value at the end of the 8 years. Both sub-projects are to commence
immediately.
Project B
This project will generate Sh.87,000,000 per annum in
perpetuity. The company has a cost of capital of 16%.
Required:
(i) Determine the net present value (NPV) of each project.
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expected to increase for the foreseeable future. The company has 900,000 outstanding
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board of directors to raise the money through a rights issue. The board has set the
subscription price at Sh.75 per share.
Required:
(i) The number of rights required to purchase a new share.
(ii) The price of one share after the rights issue.
(iii) The theoretical value of the rights if the shares are sold ex-right.
(iv) The effect on a shareholder's wealth if he decides neither to exercise nor sell
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company's daily cash changes is Sh.200,000. The annual interest rate is
14%. The transaction cost of buying or selling securities is Sh.150 per transaction.
Required:
Using the Miller-Orr cash management model, determine the following:
(i) Upper cash limit
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(iii) The return point.
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Date posted: February 11, 2019. Answers (1)
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The following information represents the financial position and financial results of
AMETEX Limited for the year ended 31 December 2002.
Required:
Determine the following financial ratios:
(i) Acid test ratio.
(ii) Operating ratio
(iii) Return on total capital employed
(iv) Price earnings ratio.
(v) Interest coverage ratio
(vi) Total assets turnover
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Date posted: February 11, 2019. Answers (1)
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The total of the net working capital and fixed assets of Faida Ltd as at 30 April 2003 was Sh.100,000,000. The company wishes to raise additional funds to finance a project within the next one year in the following manner.
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The preference shares were issued four years ago and still sell at their face value.
Assume a tax rate of 30%
Required:
(i) The expected rate of return on ordinary shares.
(ii) The effective cost to the company of:
- Debt capital
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Date posted: February 11, 2019. Answers (1)
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Required:
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(b) Identify and explain six reasons why companies in your country may seek 'cross border' listing.
(c) Identify five barriers to “cross-border” listing.
Date posted: February 11, 2019. Answers (1)