Topic: Sources of finance and cost of capital

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  • 10 Marks

AFM – May 2017 – L3 – Q4a – Sources of finance and cost of capital

Explanation of Eurobonds, their advantages, and problems associated with their use in Ghana's international borrowing.

The government of Ghana has been borrowing in the international financial market by issuing “Eurobonds” to finance projects in Ghana. There has been a keen debate on the borrowing by the government.

Required:
i) As a Finance Officer, explain what Eurobond is all about. (3 marks)
ii) Identify THREE advantages that have been cited for the government using Eurobonds. (3 marks)
iii) Evaluate FOUR problems associated with the use of international borrowing, especially Eurobonds in Ghana. (4 marks)

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  • 8 Marks

AFM – Nov 2016 – L3 – Q3a – Sources of finance and cost of capital

Calculate the cost of equity for Sunland Co using the Capital Asset Pricing Model (CAPM) with a focus on deriving beta from industry data.

a) The directors of Sunland Company, a company which has 75% of its operations in the retail
sector and 25% in manufacturing, are trying to derive the firm’s cost of equity. However, since
the company is not listed, it has been difficult to determine an appropriate beta factor. The
following information was researched:

  •  Retail industry – quoted retailers have an average equity beta of 1.20, and an average
    gearing ratio of 20:80 (debt: equity).
  • Manufacturing industry – quoted manufacturers have an average equity beta of 1.45 and
    an average gearing ratio of 45:55 (debt: equity).
  • The risk free rate is 3% and the equity risk premium is 6%.
  • Tax on corporate profits is 30%.
  •  Sunland Co has gearing ratio of 50% debt and 50% equity by market values. Assume that
    the risk on corporate debt is negligible.

Required:
Calculate the cost of equity of Sunland Company using the Capital Asset Pricing Model.

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  • 8 Marks

AFM – May 2017 – L3 – Q2b – Sources of finance and cost of capital

Calculate the cost of capital for Oheneba Limited with two different capital structures.

Oheneba Limited is considering the acquisition of a concession in the Brong Ahafo region to enable it to start a quarry business. The average industry beta is 1.6 with an equity-to-debt ratio of 2:1.

The following information was extracted from the books of Oheneba Limited:

Income Statement

You are also informed that the long-term debt of the company is considered risk-free with a gross redemption yield of 10% and the beta coefficient of the company’s equity is 1.2, while the average return on the stock market is 15%.

Required:
i) Determine the cost of capital to apply for the appraisal of the quarry if Oheneba Limited will maintain its capital structure after the implementation of the quarry project. (5 marks)
ii) Determine the cost of capital to apply if the company will change its capital structure to 20% debt and 80% equity. (3 marks)

 

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  • 10 Marks

AFM – May 2019 – L3 – Q1b – Sources of finance and cost of capital

Evaluate three financing options to meet a firm's inventory needs, considering costs and advantages.

Kaki Limited needs to finance a seasonal bulge in inventories of GH¢400,000. The funds are needed for six months. The company is considering the following possibilities:

i) Warehouse loan received from a finance company. Terms are 12 percent with an 80 percent advance against the value of the inventory. The warehousing costs are GH¢7,000 for the six-month period. The residual financing requirement, which is GH¢400,000 less the amount advanced, will need to be financed by foregoing cash discounts on its payables. Standard terms are 2/10, net 30. However, the company feels it can postpone payment until the fortieth day without adverse effect.

ii) A floating lien arrangement from the supplier of the inventory at an effective interest rate of 20 percent. The supplier will advance the full value of the inventory.

iii) A field warehouse loan from another finance company at an interest rate of 10 percent. The advance is 70 percent, and field warehousing costs amount to GH¢10,000 for the six-month period. The residual financing requirement will need to be financed by foregoing cash discounts on payables as in the first alternative.

Required:
Evaluate the feasible method of financing the inventory needs of the firm.

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  • 20 Marks

AFM – Nov 2017 – L3 – Q2 – Sources of finance and cost of capital

Calculation of the cost of capital using the WACC and CAPM methods for a company and discussing when to use the cost of equity or WACC for discounting.

Animal Farm Product Ltd, (AFP), a manufacturer of veterinary medicines for farm animals, wishes to estimate its current cost of capital.

The following figures have been extracted from their most recent accounts:

Other relevant data:

  • The current market value of AFP’s ordinary shares is GH¢12.50 per share cum-dividend. AFP’s beta is 1.4, the risk-free rate is 3%, and the return on the SEC index (the market proxy) is 8%. An annual dividend of GH¢800,000 is due for payment shortly.
  • The 8% debentures are irredeemable and are trading at a current market value of GH¢106.00, a GH¢6.00 premium over their issue price of GH¢100.00. Semi-annual interest of GH¢4 million has just been paid on the debentures.
  • The 6% preference shares are trading at a current market value of GH¢6.00, a GH¢1 above their issue price of GH¢5.00. Interest has just been paid on these preference shares.
  • There have been no issues or redemptions of ordinary shares or debentures during the past five years, and the corporation tax rate remains at 12.5%. Assume that tax relief on the debenture interest arises at the same time as the interest payment.

Required:

a) Calculate the cost of capital that AFP should use as a discount rate when appraising new marginal investment opportunities. (11 marks)

b) Explain when firms should discount projects using:

  • The cost of equity;
  • The WACC instead; and
  • When should they use neither? You may use the information and your results in part (a) as examples. (6 marks)

c) Discuss what type of covenants might be attached to bonds. (3 marks)

 

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  • 6 Marks

AFM – Nov 2017 – L3 – Q1b – Sources of finance and cost of capital

Analyzing financing alternatives for working capital of GH¢100,000 through bank loan, promissory notes, and cash discount.

Abbot Ltd needs to increase its working capital by GH¢100,000. It has decided that there are essentially three alternatives of financing available. They are:

i) Borrow from a bank at 8%. This alternative would necessitate maintaining a 25% compensation balance.

ii) Issue promissory notes at 7.5%. The cost of placing the issue would be GH¢500 each six months.

iii) Forego cash discount, granted on the basis of 3/10, net 30.

The firm prefers the flexibility of bank financing, and has provided an additional cost of this flexibility to be 1%.

Required: Assess which alternative financing method should be selected.

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  • 20 Marks

AFM – Nov 2015 – L3 – Q3 – Sources of Finance and Cost of Capital

Estimate the cost of debt using the Kaplan Urwitz model and assess default probability and expected loss for subordinated bonds.

Lolonyo Foam Ltd (Lolonyo), an Accra-based unlisted company, has been manufacturing mattresses and other foam products since 1990. The company is considering a new project which requires a GHS75 million investment in capital expenditure and net working capital. The directors of Lolonyo have decided to raise the needed funds through a new issue of 10-year subordinated bonds to investors in Ghana. Lolonyo uses a discount rate of 20% to appraise new projects. However, the directors feel that this rate will not be appropriate for this project as its financing method is different from what has been used in the past.

The following information is available for the company:
Total assets: GHS150m
Long-term debt: GHS80m
Net income: GHS10.2m
Net income before interest and taxes: GHS14.8m
Interest payments: GHS1.2m
Tax rate: 25%

Earnings of the company for the past five years are as follows:

Year Earnings (GHS’m)
2014 9.8
2013 9.2
2012 8.5
2011 8.1
2010 8.4

Directors intend to use the Kaplan Urwitz model for unlisted companies to assess the cost of debt. The Kaplan Urwitz model for unlisted companies is given by:

Y=4.41+0.001(Size)+6.40(Profitability)−2.56(Debt)−2.72(Leverage)+0.006(Interest)−0.53(COV)

Where:

  • Y is the credit score
  • Size is measured by total assets
  • Profitability is measured by the ratio of net income to total assets
  • Debt refers to the status of the debt stock; subordinated debt is assigned score 1, and unsubordinated debt is assigned score 0
  • Leverage is measured by the ratio of long-term debt to total assets
  • Interest refers to interest cover, which is measured by net operating income (i.e. net income before interest and tax)
  • COV is the coefficient of variation in earnings, which measures volatility in earnings

The table below presents credit score ranges and corresponding rating categories and yields to maturity for 10-year corporate bonds:

Score (Y) Rating Category Yield to Maturity
Y > 6.76 AAA 22.0%
Y > 5.19 AA 22.5%
Y > 3.28 A 23.2%
Y > 1.57 BBB 24.2%
Y > 0 BB 25.5%

Required:
(a) Estimate the cost of debt. (8 marks)

(b) Suppose Lolonyo applies to a credit rating agency for rating of its debt. Explain any THREE (3) of the criteria the credit rating agency would use in establishing the company’s credit rating. For each criterion, suggest one factor that can be used to assess it. (6 marks)

(c) Suppose the fair market value of assets is GHS200 million and the face value of the 10-year bonds is GHS80 million. The risk-free rate is 18% and the volatility of asset value is 50%.

(i) Find the value of the default probability using the Black-Scholes option pricing model. (3 marks)

(ii) Estimate the expected loss on the bonds if the recovery rate is 60%. (3 marks)
(Total = 20 marks)

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  • 20 Marks

AFM – Nov 2015 – L3 – Q2 – Discounted Cash Flow Techniques | Sources of Finance and Cost of Capital

Evaluate the financial viability of a proposed air conditioner manufacturing project using APV.

ABC Manufacturing Ltd (ABC) is an indigenous Ghanaian company that manufactures components used in air conditioners. The company now wants to manufacture air conditioners for sale in Ghana. Though the manufacture of air conditioners will be a completely new business, directors of ABC plan to integrate it into the company’s core business.

ABC has premises it considers suitable for the project. This premises was acquired two years ago at the cost of GHS50,000. ABC will acquire and install the needed machinery immediately, so production and sales can commence during the first year. The directors of ABC intend to develop the project for five years and then sell it to a suitable investor for an after-tax consideration of GHS20 million.

The following data are available for the project:

  1. The cost of acquiring and installing plant and machinery needed for the project will be GHS5 million at the start of the first year. Tax-allowable depreciation is available on the plant and machinery at the rate of 30% on reducing balance basis.
  2. Working capital requirement for each year is equal to 10% of the year’s anticipated sales. ABC has to make working capital available at the beginning of the respective year. It is expected that 40% of working capital will be redeployed to other projects at the end of the fifth year when the project is sold.
  3. It is expected that 2,000 units will be manufactured and sold in the first year. Unit sales will grow by 5% each year thereafter.
  4. Unit sales price is estimated at GHS2,200 in the first year. Thereafter, the unit sales price is expected to be increased by 10% each year.
  5. Unit variable cost will be GHS1,100 per unit in the first year. Unit variable cost is expected to increase by 8% each year after the first year.
  6. Fixed overhead costs are estimated at GHS1.5 million in total in each year of production/sale. One-half of the total fixed overhead costs are head office allocated overheads. After the first year of production/sales, fixed overhead costs are expected to increase by 5% per year.

ABC Ltd pays tax at 25% on taxable profits. Tax is payable in the same year the profit is earned. ABC Ltd uses 25% as its discount rate for new projects but the directors feel that this rate may not be appropriate for this new venture.

Currently, ABC can borrow at 500 basis points above the five-year Treasury note yield rate. Ghana’s government is enthused by the venture and has offered ABC a subsidized loan of up to 60% of the investment funds required at an interest rate of 200 basis points above the five-year Treasury note yield rate. ABC plans to use debt capital to finance the project by taking advantage of the government’s subsidized loan and raising the balance through a fresh issue of 5-year debentures. Issues costs, which can be assumed to be tax-deductible expenses, will be 5% of the gross proceeds from the debenture offer. The financing strategy for the project is not expected to affect the company’s borrowing capacity in any way.

ABC Ltd will be the first indigenous Ghanaian company to manufacture air conditioners in Ghana. However, it will be competing with XYZ Ltd, a listed company with majority shares held by foreign investors. The cost of equity of XYZ Ltd is estimated to be 20% and it pays tax at 22%. XYZ has 10 million shares in issue that are trading at GHS5.5 each, and bonds with total market value of GHS40 million.

The five-year Treasury note yield rate is currently 10% and the return on the market portfolio is 18%.

Required:
Evaluate, on financial grounds, whether ABC should implement the project or not. (20 marks)

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  • 6 Marks

AFM – May 2016 – L3 – Q4d – Sources of finance and cost of capital

Calculate the theoretical ex-right price, value of rights, and analyze the effects of a rights issue on a shareholder's wealth.

d) Agoro Limited has issued 75,000 equity shares of GH¢0.10 each. The current market price per share is GH¢24. The Company has decided to make a rights issue of one (1) new equity share at a price of GH¢16 for every four (4) shares held.

Required:
i) Calculate the theoretical ex-right price per share.

(2 marks)
ii) Calculate the theoretical value of the right. (1 mark)
iii) Mr. Crentsil currently holds 1,000 shares in Agoro Limited, show the effect of the rights issue on his wealth assuming he sells the entire right. (2 marks)
iv) Calculate the effect if Mr. Crentsil does not take any action and ignores the right issue. (1 mark)

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  • 4 Marks

AFM – May 2016 – L3 – Q2c – Sources of finance and cost of capital, Theories of capital structure

Calculate the cost of debt after tax for a discounted debenture issued by Brown Limited.

c) Ten years ago, Brown Limited issued GH¢2.5 million of 6% discounted debentures at GH¢98 per 100 nominal. The debentures are redeemable in 5 years from now at GH¢2 premium over nominal value. They are currently quoted at GH¢80 per debenture ex-interest. Brown Limited pays corporate tax at the rate of 30%.

You are required to calculate the cost of debt after tax.

(4 marks)

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  • 10 Marks

AFM – May 2017 – L3 – Q4a – Sources of finance and cost of capital

Explanation of Eurobonds, their advantages, and problems associated with their use in Ghana's international borrowing.

The government of Ghana has been borrowing in the international financial market by issuing “Eurobonds” to finance projects in Ghana. There has been a keen debate on the borrowing by the government.

Required:
i) As a Finance Officer, explain what Eurobond is all about. (3 marks)
ii) Identify THREE advantages that have been cited for the government using Eurobonds. (3 marks)
iii) Evaluate FOUR problems associated with the use of international borrowing, especially Eurobonds in Ghana. (4 marks)

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  • 8 Marks

AFM – Nov 2016 – L3 – Q3a – Sources of finance and cost of capital

Calculate the cost of equity for Sunland Co using the Capital Asset Pricing Model (CAPM) with a focus on deriving beta from industry data.

a) The directors of Sunland Company, a company which has 75% of its operations in the retail
sector and 25% in manufacturing, are trying to derive the firm’s cost of equity. However, since
the company is not listed, it has been difficult to determine an appropriate beta factor. The
following information was researched:

  •  Retail industry – quoted retailers have an average equity beta of 1.20, and an average
    gearing ratio of 20:80 (debt: equity).
  • Manufacturing industry – quoted manufacturers have an average equity beta of 1.45 and
    an average gearing ratio of 45:55 (debt: equity).
  • The risk free rate is 3% and the equity risk premium is 6%.
  • Tax on corporate profits is 30%.
  •  Sunland Co has gearing ratio of 50% debt and 50% equity by market values. Assume that
    the risk on corporate debt is negligible.

Required:
Calculate the cost of equity of Sunland Company using the Capital Asset Pricing Model.

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  • 8 Marks

AFM – May 2017 – L3 – Q2b – Sources of finance and cost of capital

Calculate the cost of capital for Oheneba Limited with two different capital structures.

Oheneba Limited is considering the acquisition of a concession in the Brong Ahafo region to enable it to start a quarry business. The average industry beta is 1.6 with an equity-to-debt ratio of 2:1.

The following information was extracted from the books of Oheneba Limited:

Income Statement

You are also informed that the long-term debt of the company is considered risk-free with a gross redemption yield of 10% and the beta coefficient of the company’s equity is 1.2, while the average return on the stock market is 15%.

Required:
i) Determine the cost of capital to apply for the appraisal of the quarry if Oheneba Limited will maintain its capital structure after the implementation of the quarry project. (5 marks)
ii) Determine the cost of capital to apply if the company will change its capital structure to 20% debt and 80% equity. (3 marks)

 

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  • 10 Marks

AFM – May 2019 – L3 – Q1b – Sources of finance and cost of capital

Evaluate three financing options to meet a firm's inventory needs, considering costs and advantages.

Kaki Limited needs to finance a seasonal bulge in inventories of GH¢400,000. The funds are needed for six months. The company is considering the following possibilities:

i) Warehouse loan received from a finance company. Terms are 12 percent with an 80 percent advance against the value of the inventory. The warehousing costs are GH¢7,000 for the six-month period. The residual financing requirement, which is GH¢400,000 less the amount advanced, will need to be financed by foregoing cash discounts on its payables. Standard terms are 2/10, net 30. However, the company feels it can postpone payment until the fortieth day without adverse effect.

ii) A floating lien arrangement from the supplier of the inventory at an effective interest rate of 20 percent. The supplier will advance the full value of the inventory.

iii) A field warehouse loan from another finance company at an interest rate of 10 percent. The advance is 70 percent, and field warehousing costs amount to GH¢10,000 for the six-month period. The residual financing requirement will need to be financed by foregoing cash discounts on payables as in the first alternative.

Required:
Evaluate the feasible method of financing the inventory needs of the firm.

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  • 20 Marks

AFM – Nov 2017 – L3 – Q2 – Sources of finance and cost of capital

Calculation of the cost of capital using the WACC and CAPM methods for a company and discussing when to use the cost of equity or WACC for discounting.

Animal Farm Product Ltd, (AFP), a manufacturer of veterinary medicines for farm animals, wishes to estimate its current cost of capital.

The following figures have been extracted from their most recent accounts:

Other relevant data:

  • The current market value of AFP’s ordinary shares is GH¢12.50 per share cum-dividend. AFP’s beta is 1.4, the risk-free rate is 3%, and the return on the SEC index (the market proxy) is 8%. An annual dividend of GH¢800,000 is due for payment shortly.
  • The 8% debentures are irredeemable and are trading at a current market value of GH¢106.00, a GH¢6.00 premium over their issue price of GH¢100.00. Semi-annual interest of GH¢4 million has just been paid on the debentures.
  • The 6% preference shares are trading at a current market value of GH¢6.00, a GH¢1 above their issue price of GH¢5.00. Interest has just been paid on these preference shares.
  • There have been no issues or redemptions of ordinary shares or debentures during the past five years, and the corporation tax rate remains at 12.5%. Assume that tax relief on the debenture interest arises at the same time as the interest payment.

Required:

a) Calculate the cost of capital that AFP should use as a discount rate when appraising new marginal investment opportunities. (11 marks)

b) Explain when firms should discount projects using:

  • The cost of equity;
  • The WACC instead; and
  • When should they use neither? You may use the information and your results in part (a) as examples. (6 marks)

c) Discuss what type of covenants might be attached to bonds. (3 marks)

 

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  • 6 Marks

AFM – Nov 2017 – L3 – Q1b – Sources of finance and cost of capital

Analyzing financing alternatives for working capital of GH¢100,000 through bank loan, promissory notes, and cash discount.

Abbot Ltd needs to increase its working capital by GH¢100,000. It has decided that there are essentially three alternatives of financing available. They are:

i) Borrow from a bank at 8%. This alternative would necessitate maintaining a 25% compensation balance.

ii) Issue promissory notes at 7.5%. The cost of placing the issue would be GH¢500 each six months.

iii) Forego cash discount, granted on the basis of 3/10, net 30.

The firm prefers the flexibility of bank financing, and has provided an additional cost of this flexibility to be 1%.

Required: Assess which alternative financing method should be selected.

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  • 20 Marks

AFM – Nov 2015 – L3 – Q3 – Sources of Finance and Cost of Capital

Estimate the cost of debt using the Kaplan Urwitz model and assess default probability and expected loss for subordinated bonds.

Lolonyo Foam Ltd (Lolonyo), an Accra-based unlisted company, has been manufacturing mattresses and other foam products since 1990. The company is considering a new project which requires a GHS75 million investment in capital expenditure and net working capital. The directors of Lolonyo have decided to raise the needed funds through a new issue of 10-year subordinated bonds to investors in Ghana. Lolonyo uses a discount rate of 20% to appraise new projects. However, the directors feel that this rate will not be appropriate for this project as its financing method is different from what has been used in the past.

The following information is available for the company:
Total assets: GHS150m
Long-term debt: GHS80m
Net income: GHS10.2m
Net income before interest and taxes: GHS14.8m
Interest payments: GHS1.2m
Tax rate: 25%

Earnings of the company for the past five years are as follows:

Year Earnings (GHS’m)
2014 9.8
2013 9.2
2012 8.5
2011 8.1
2010 8.4

Directors intend to use the Kaplan Urwitz model for unlisted companies to assess the cost of debt. The Kaplan Urwitz model for unlisted companies is given by:

Y=4.41+0.001(Size)+6.40(Profitability)−2.56(Debt)−2.72(Leverage)+0.006(Interest)−0.53(COV)

Where:

  • Y is the credit score
  • Size is measured by total assets
  • Profitability is measured by the ratio of net income to total assets
  • Debt refers to the status of the debt stock; subordinated debt is assigned score 1, and unsubordinated debt is assigned score 0
  • Leverage is measured by the ratio of long-term debt to total assets
  • Interest refers to interest cover, which is measured by net operating income (i.e. net income before interest and tax)
  • COV is the coefficient of variation in earnings, which measures volatility in earnings

The table below presents credit score ranges and corresponding rating categories and yields to maturity for 10-year corporate bonds:

Score (Y) Rating Category Yield to Maturity
Y > 6.76 AAA 22.0%
Y > 5.19 AA 22.5%
Y > 3.28 A 23.2%
Y > 1.57 BBB 24.2%
Y > 0 BB 25.5%

Required:
(a) Estimate the cost of debt. (8 marks)

(b) Suppose Lolonyo applies to a credit rating agency for rating of its debt. Explain any THREE (3) of the criteria the credit rating agency would use in establishing the company’s credit rating. For each criterion, suggest one factor that can be used to assess it. (6 marks)

(c) Suppose the fair market value of assets is GHS200 million and the face value of the 10-year bonds is GHS80 million. The risk-free rate is 18% and the volatility of asset value is 50%.

(i) Find the value of the default probability using the Black-Scholes option pricing model. (3 marks)

(ii) Estimate the expected loss on the bonds if the recovery rate is 60%. (3 marks)
(Total = 20 marks)

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  • 20 Marks

AFM – Nov 2015 – L3 – Q2 – Discounted Cash Flow Techniques | Sources of Finance and Cost of Capital

Evaluate the financial viability of a proposed air conditioner manufacturing project using APV.

ABC Manufacturing Ltd (ABC) is an indigenous Ghanaian company that manufactures components used in air conditioners. The company now wants to manufacture air conditioners for sale in Ghana. Though the manufacture of air conditioners will be a completely new business, directors of ABC plan to integrate it into the company’s core business.

ABC has premises it considers suitable for the project. This premises was acquired two years ago at the cost of GHS50,000. ABC will acquire and install the needed machinery immediately, so production and sales can commence during the first year. The directors of ABC intend to develop the project for five years and then sell it to a suitable investor for an after-tax consideration of GHS20 million.

The following data are available for the project:

  1. The cost of acquiring and installing plant and machinery needed for the project will be GHS5 million at the start of the first year. Tax-allowable depreciation is available on the plant and machinery at the rate of 30% on reducing balance basis.
  2. Working capital requirement for each year is equal to 10% of the year’s anticipated sales. ABC has to make working capital available at the beginning of the respective year. It is expected that 40% of working capital will be redeployed to other projects at the end of the fifth year when the project is sold.
  3. It is expected that 2,000 units will be manufactured and sold in the first year. Unit sales will grow by 5% each year thereafter.
  4. Unit sales price is estimated at GHS2,200 in the first year. Thereafter, the unit sales price is expected to be increased by 10% each year.
  5. Unit variable cost will be GHS1,100 per unit in the first year. Unit variable cost is expected to increase by 8% each year after the first year.
  6. Fixed overhead costs are estimated at GHS1.5 million in total in each year of production/sale. One-half of the total fixed overhead costs are head office allocated overheads. After the first year of production/sales, fixed overhead costs are expected to increase by 5% per year.

ABC Ltd pays tax at 25% on taxable profits. Tax is payable in the same year the profit is earned. ABC Ltd uses 25% as its discount rate for new projects but the directors feel that this rate may not be appropriate for this new venture.

Currently, ABC can borrow at 500 basis points above the five-year Treasury note yield rate. Ghana’s government is enthused by the venture and has offered ABC a subsidized loan of up to 60% of the investment funds required at an interest rate of 200 basis points above the five-year Treasury note yield rate. ABC plans to use debt capital to finance the project by taking advantage of the government’s subsidized loan and raising the balance through a fresh issue of 5-year debentures. Issues costs, which can be assumed to be tax-deductible expenses, will be 5% of the gross proceeds from the debenture offer. The financing strategy for the project is not expected to affect the company’s borrowing capacity in any way.

ABC Ltd will be the first indigenous Ghanaian company to manufacture air conditioners in Ghana. However, it will be competing with XYZ Ltd, a listed company with majority shares held by foreign investors. The cost of equity of XYZ Ltd is estimated to be 20% and it pays tax at 22%. XYZ has 10 million shares in issue that are trading at GHS5.5 each, and bonds with total market value of GHS40 million.

The five-year Treasury note yield rate is currently 10% and the return on the market portfolio is 18%.

Required:
Evaluate, on financial grounds, whether ABC should implement the project or not. (20 marks)

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  • 6 Marks

AFM – May 2016 – L3 – Q4d – Sources of finance and cost of capital

Calculate the theoretical ex-right price, value of rights, and analyze the effects of a rights issue on a shareholder's wealth.

d) Agoro Limited has issued 75,000 equity shares of GH¢0.10 each. The current market price per share is GH¢24. The Company has decided to make a rights issue of one (1) new equity share at a price of GH¢16 for every four (4) shares held.

Required:
i) Calculate the theoretical ex-right price per share.

(2 marks)
ii) Calculate the theoretical value of the right. (1 mark)
iii) Mr. Crentsil currently holds 1,000 shares in Agoro Limited, show the effect of the rights issue on his wealth assuming he sells the entire right. (2 marks)
iv) Calculate the effect if Mr. Crentsil does not take any action and ignores the right issue. (1 mark)

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  • 4 Marks

AFM – May 2016 – L3 – Q2c – Sources of finance and cost of capital, Theories of capital structure

Calculate the cost of debt after tax for a discounted debenture issued by Brown Limited.

c) Ten years ago, Brown Limited issued GH¢2.5 million of 6% discounted debentures at GH¢98 per 100 nominal. The debentures are redeemable in 5 years from now at GH¢2 premium over nominal value. They are currently quoted at GH¢80 per debenture ex-interest. Brown Limited pays corporate tax at the rate of 30%.

You are required to calculate the cost of debt after tax.

(4 marks)

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