Chuma Company Ltd is considering various levels of debt. Currently it has no debt. It has a totalmarket value of Sh.30 million. By undertaking debt it believes that it can achieve a net tax advantageequal to 20% of the amount of debt. However the company will incur bankruptcy and agency costsas well as lenders increasing their interest rate if it borrows too much. The company‟smanaging director believes that the company can borrow up to Sh.10 million without incurringany of these costs. However, each additional Sh.10 million increment in borrowing is expected toresult in the three costs cited being incurred. Moreover, the three costs are expected to increase atan increasing rate with leverage. The present value cost of various levels of debt is as follows:Required:Advise the managing director on the optimal amount of debt for Chuma Company.
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Mr. Mlachake is currently holding a portfolio consisting of shares of four companies quoted on the Bahati Stock Exchange as follows:The current market return is 14% per annum and the treasury bills yield is 9% per annum.Required:(i) Calculate the risk of Mlachake‟s portfolio relative to that of the market.(ii) Explain whether or not Mlachake should change the composition of his portfolio.
Date posted: April 16, 2021. Answers (1)
Briefly explain three practical uses of the capital asset pricing model.
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