Advantages of debt financing

A) Current Dividend (D0) per share = $2.5

Dividend Growth Rate (g) = 6%

P0 (market price per share) = $50

Expenses of Floatation (f) = 10%

Capital Cost = D1 (1-f) + g, P0 D1 = D0 (1 + g) = 2.50 (1 + 0.06) = 2.65

Equity capital cost = 2.65 + 6%

50(1-0.01)\s= 0.1189 or 11.89%

Benefits of New Equity

Although the company would owe the investors a percentage of the earnings, there is no interest payment.

Because the investors take a blow if the business fails, equity finance has no liability.

The Drawbacks of New Equity

There is no Equity financing call of share of profits with investors

There is loss of control or ownership of the firm

Raising equity capital is costly, demanding and consumes a lot of time demanding.

Raising equity finance require complying with many regulation

need to save capital for meeting debt as there are not monthly payment

B. The Pre-Tax Cost of Debt equals market rate for the same debt.

Given the pre-tax cost of debt = 5%, then;

After-Tax Cost of Debt = Pre-Tax Cost of Debt (1-Marginal Tax Rate)

= 5% (1-35%) = 3.25%

Advantages of debt financing

It helps retain the ownership or control of the company has investors or banks does not have to acquire the control

It provides tax advantage because the interest paid on debt is tax deductible

Disadvantages of debt financing

It is costly due to interest paid to investors

It applies strict lending requirement which may be difficult for start-up companies to get It increases liability of the business because it requires collateral for the funds to be provided

It is a borrowing against future earnings, and this means that future earnings would not be used to for business growth but payment to owners

C). WACC = We*Re + Wd (1­t) Rd

Where Re = Cost of new Equity, Rd =Cost of Debt, We = proportions of new Equity and Wd= proportions Debt

But We = 70% and Wd = 30%

Hence WACC = 70%*11.89% + 30% *3.25%= 9.3%

WACC is important in capital budgeting process. It is the average of the cost of all the all the sources of finance. Each capital project is weighted by use in a given situation. WACC help firm to see how much interest a firm has to pay each dollar it finances.

D).Depreciation = Cost of the asset – salvage value

Life of the asset

= 1,500,000/ 3

= 500,000

Calculation of cash flows:

Revenue 1,200,000

Less Cost 600,000

Less Depreciation 500,000

Profit before Tax (PBT) 100,000

Less taxes (35%*$100,000) 35,000

Profit after Taxes (PAT) 65,000

Add depreciation 500,000

Cash flow after taxes 565,000

E). given that;

Discount Rate =6% then,

NPV = Present value of cash flows – initial Cash outlay

= 565,000 x PVIFA 6%, 3 years – 1,500,000

= 565,000 x 2.6730 – 1,500,000

= 1,510,245 – 1,500,000

= 10,251.75

The NPV of the project is positive and therefore acceptable. The Positive NPV implies that it means that discounted cash inflows are more than the discounted cash outflows. The project is thus economically acceptable and add value to the firm.

F). The IRR the discount rate at which the NPV of the project equals zero

Therefore if r% is the IRR of the project, then we can calculate it as follows

0= 565,000 x PVIFA r%, 3 years – 1,200,000

Using excel software the IRR(r %) of the project would be equal = 19.48%.

The IRR rule of acceptance or rejection state that projects with IRR greater than the cost of capital should be accepted while those with IRR lower than the cost of capital should be rejected. In this case, the IRR is more than the calculated WACC of 9.3% from part (c). The project should, therefore, be accepted as this indicate that at the cost of capital of 9.3% it would have positive NPV.

G). Expected After-tax Cash Flows = Sum of (Probability * After-tax Cash Flow)

The expected after tax cash flow for investment B and C are shown below

Investment B

Expected after tax Cash flow

Investment C

Expected after tax Cash flow

Probability

After Tax Cash Flow

Probability

After Tax Cash Flow

0.25

$20,000

$5000

0.30

$22,000

$6600

0.50

32,000

$16000

0.50

40,000

$20000

0.25

40,000

$10000

0.20

50,000

$10000

Total

$31000

$36600

Each project investment = $120,000. Using excel the IRR of the Project B = 14.17% and that of C = 20.57%. The NPV rule state that a project should be accepted as long as the NPV of the project is positive. However, if IRR is less than the cost of capital and NPV is positive then there will be conflicts as to whether to accept or reject the project. In this case, IRR of the projects is more than WACC of 9.3% and the NPV is positive meaning that both the techniques lead to the same conclusion of accepting initiative.

H). Adjusted NPV at discount 8%.

Project B

NPV = Present value of cash flows – initial Cash outlay

= $31,000 x PVIFA 8%, 6 years – $120,000

= $31,000 x 4.6229-$120,000

=$23309.9

Project C

NPV = Present value of cash flows – initial Cash outlay

= $36,600 x PVIFA 8%, 6 years – $120,000

= $36,600 x 4.6229-$120,000

=$ 49198.14

Both Project B and have positive NPV and hence acceptable for investment if there is funds. However, if there is no adequate funds to finance the two projects then the one with the highest NPV should be considered and in this case project C would be worthwhile.