Get premium membership and access questions with answers, video lessons as well as revision papers.
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
- Identify four factors that have limited the development of the venture capital market in
your country.(Solved)
Identify four factors that have limited the development of the venture capital market in
your country.
Date posted: February 11, 2019. Answers (1)
- Differentiate between the following pairs of terms
(i) Market value and intrinsic value of a share.
(ii) Weighted cost of capital and marginal cost of capital....(Solved)
Differentiate between the following pairs of terms:
(i) Market value and intrinsic value of a share.
(ii) Weighted cost of capital and marginal cost of capital.
(iii) Capital structure and financial structure.
(iv) Formal markets and over-the-counter markets.
Date posted: February 11, 2019. Answers (1)
- Highlight four factors that may underlie the low rate of listing of companies in a stock
exchange you are familiar with.(Solved)
Highlight four factors that may underlie the low rate of listing of companies in a stock
exchange you are familiar with.
Date posted: February 11, 2019. Answers (1)
- Briefly describe the three forms of capital market efficiency(Solved)
Briefly describe the three forms of capital market efficiency
Date posted: February 11, 2019. Answers (1)
- How does a company's working capital policy impact on its liquidity – profitability
position? Explain with reference to the strategies available to the firm for financing...(Solved)
How does a company's working capital policy impact on its liquidity – profitability
position? Explain with reference to the strategies available to the firm for financing its
working capital.
Date posted: February 11, 2019. Answers (1)
- Briefly explain the liquidity – profitability trade – off which a business enterprise may be
required to consider in its financial management policies.(Solved)
Briefly explain the liquidity – profitability trade – off which a business enterprise may be
required to consider in its financial management policies.
Date posted: February 11, 2019. Answers (1)
- 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...(Solved)
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
Swaleh Ltd. on which alternative to accept.
(iv) 'It is always better for a company to use debt finance since lower cost of debt
results in higher earnings per share'.
Briefly comment on this statement.
Date posted: February 11, 2019. Answers (1)
- Distinguish between financial risk and operating risk.(Solved)
Distinguish between financial risk and operating risk.
Date posted: February 11, 2019. Answers (1)
- Magma Ltd. wishes to make a choice between two mutually exclusive projects. Each of
these projects requires Sh.400,000,000 in initial cash outlay. The details of the...(Solved)
Magma Ltd. wishes to make a choice between two mutually exclusive projects. Each of
these projects requires Sh.400,000,000 in initial cash outlay. The details of the two
projects are as follows:
Project A
This project is made up of two sub-projects. The first sub-project will require an initial
outlay of Sh.100,000,000 and will generate Sh.25,600,000 per annum in perpetuity. The
second sub-project will require an initial outlay of Sh.300,000,000 and will generate
Sh.85,200,000 per annum for the 8 years of its useful life. This sub-project does not
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.
(ii) Compute the internal rate of return (IRR) for each project.
(iii) Advise Magma Ltd. on which project to invest in, and justify your choice
Date posted: February 11, 2019. Answers (1)
- Joseph Kimeu is trying to determine the value of Bidii Ltd.'s ordinary shares. The
earnings growth rate over his planned six-year holding period is estimated to...(Solved)
Joseph Kimeu is trying to determine the value of Bidii Ltd.'s ordinary shares. The
earnings growth rate over his planned six-year holding period is estimated to be 10%,
and the dividend payout ratio is 60%. The ending price earnings (P/E) ratio is expected
to be 20 and the current earnings per share are Sh.4. The required rate of return for this
share is 15%.
Required:
Compute the market price of Bidii Ltd's ordinary share
Date posted: February 11, 2019. Answers (1)
- (a) Briefly explain how the 'Dow Theory' views the movement of the market prices of
shares traded on a stock exchange.
(b) Identify and briefly explain the...(Solved)
(a) Briefly explain how the 'Dow Theory' views the movement of the market prices of
shares traded on a stock exchange.
(b) Identify and briefly explain the factors that must be taken into account in the design and
construction of a market index for shares.
Date posted: February 11, 2019. Answers (1)
- (a) Outline the factors which contributed to the popularity of commercial papers over bank
overdrafts among large corporations in the 1990s.
(b) Clearly distinguish between 'factoring'...(Solved)
(a) Outline the factors which contributed to the popularity of commercial papers over bank
overdrafts among large corporations in the 1990s.
(b) Clearly distinguish between 'factoring' and 'invoice discounting' in the context of the
management of debtors.
(c) 'Not all new issues of shares are underwritten, but it is clearly better to arrange that they
should be if there is any chance than the issue may be unsuccessful'. Briefly comment
on this statement.
Date posted: February 11, 2019. Answers (1)
- (a) Briefly explain the difference between a broker and a dealer in the stock market.
(b) What are the advantages of having a dealer in a...(Solved)
(a) Briefly explain the difference between a broker and a dealer in the stock market.
(b) What are the advantages of having a dealer in a stock market? (6 marks)
(c) (i)What are the advantages of a central depository system (CDS) for a stock
market?
(ii) What problems are likely to be experienced in the initial introduction of a
central depository system (CDS) in a stock market? (4 marks)
Date posted: February 11, 2019. Answers (1)
- (a) Ujuzi Limited wishes to raise finance to cater for the purchase of new fixed assets, as its
sales level has greatly increased in the recent...(Solved)
(a) Ujuzi Limited wishes to raise finance to cater for the purchase of new fixed assets, as its
sales level has greatly increased in the recent years, and the demand for its products is
expected to increase for the foreseeable future. The company has 900,000 outstanding
shares which are currently trading in the stock exchange at Sh.130 a share. The finance
manager estimates that the fixed assets will cost Sh.22,500,000 and he has convinced the
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
the right.
(b) PKG Ltd. maintains a minimum cash balance of Sh.500,000. The deviation of the
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
(ii) Average cash balance
(iii) The return point.
(c) Explain briefly the meaning of the term 'over trading'.
Date posted: February 11, 2019. Answers (1)
- The following information represents the financial position and financial results of
AMETEX Limited for the year ended 31 December 2002.
(Solved)
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
(c) Determine the working capital cycle for the company.
Date posted: February 11, 2019. Answers (1)
- Outline four limitations of the use of ratios as a basis of financial analysis.(Solved)
Outline four limitations of the use of ratios as a basis of financial analysis.
Date posted: February 11, 2019. Answers (1)
- Alima Ltd., a manufacturer of edible oils, is contemplating the purchase of a new oil
processing machine to replace the existing one. The existing machine was...(Solved)
Alima Ltd., a manufacturer of edible oils, is contemplating the purchase of a new oil processing machine to replace the existing one. The existing machine was acquired two years ago at a cost of Sh.4,000,000. the useful life of this machine was originally
expected to be five years with no salvage value, but after a critical analysis, the financial analyst has now estimated that the machine will have an economic life of ten years with a salvage value of Sh.500,000. The new machine is estimated to cost Sh.8,000,000 and Sh.400,000 would be incurred in installing the machine. The new machine is estimated to have a useful life of ten years. An expert in asset valuation estimates that the existing machine can be sold at Sh.2,500,000 in the open market. The new machine is expected to lead to increased sales. To support the increased sales, debtors would increase by Sh.320,000, stock by Sh.140,000 and creditors by Sh.300,000. The estimated profit before depreciation and tax over the next ten years for the two machines is as given below.
The company's cost of capital is 10%. Corporation tax applicable is 30%.
The company uses the straight line method of depreciation.
Required:
(i) Initial investment required replacement of the old machine.
(ii) An evaluation of whether it is worthwhile for to undertake the replacement of the machine.
Date posted: February 11, 2019. Answers (1)
- Briefly explain the importance of capital budgeting in a business organization.(Solved)
Briefly explain the importance of capital budgeting in a business organization.
Date posted: February 11, 2019. Answers (1)
- 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...(Solved)
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.
The current market value of the company's ordinary shares is Sh.30. The expected dividend on ordinary shares by 30 April 2004 is forecast at Sh.1.20 per share. The average growth rate in both earnings and dividends has been 10% over the last 10
years and this growth rate is expected to be maintained in the foreseeable future. The debentures of the company have a face value of Sh.150. However, they currently sell for Sh.100. The debentures will mature in 100 years.
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
- Preference share capital
(iii) The company's existing weighted average cost of capital.
(iv) The company's marginal cost of capital if it raised the additional Sh.50,000,000 as intended.
Date posted: February 11, 2019. Answers (1)
- In recent years, there has been a trend towards “cross-border” listing of securities of
quoted companies. This has reduced the over-reliance by companies on domestic capital...(Solved)
In recent years, there has been a trend towards 'cross-border' listing of securities of
quoted companies. This has reduced the over-reliance by companies on domestic capital markets.
Required:
(a) Explain the meaning of 'cross-border' listing.
(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)