Equity Financing and Investment Appraisal Techniques

Knowledge

• Critically evaluate fundamental strategic decisions that a business may have to make and appreciate how accounting and finance can guide in making effective
• Show analytical skills in key decision areas within strategy and finance at local and international levels
• Critically analyze the limitations of the current state of financial theory in making strategic business decisions.

Skills

• Use Key evaluation concepts and methodologies of financial decision-making in order to contribute to the effective decision-making of the organization 

You are required to answer any TWO questions.

Question 1: Cost of capital and capital structure

The finance director of Keflex plc is recently reviewing the capital structure of her company. She identifies that the company is not financing itself in a way that minimizes its cost of capital (WACC). The company’s financing as at 31 December 2017 is as follows: 

Other information from the stock market (as at 31 December 2017): 

Ordinary share price (ex-div) £2.65

                          Preference share price (ex-div) 75p

                          Bond price for 10% bonds is £107 per £100

                          Last 5 years’ dividends (most recent last) 21p, 23p, 25p 27p, 28p

The finance director analyses that by issuing more debt the company will be able to minimize the cost of capital. She suggests the issue of £15m of 11 percent bonds. These bonds will be sold at a 5 percent premium to their par value and will mature after seven years. The funds raised will be used to repurchase ordinary shares which the company will then cancel. She expects the repurchase will cause the company’s share price to rise to £2.85 and the future dividend growth rate to increase by 20 percent (in relative terms). She expects the price of the 10 percent bonds to be unaffected, but the price of the preference shares to fall to 68p. Corporate tax stands at 30 percent.

(a) Calculate the book value and market value cost of capital (WACC) for Kadlec plc.

(b) Identify the proposed changes to Kadlec’s capital structure, recalculate the company’s cost of capital to reflect these changes, and comment on the finance director’s projections.

• Evaluate whether you consider that companies, by integrating a sensible level of enhancement into their capital structure, can minimize their weighted average cost of capital.
• Identify the effects of short-termism on bankruptcy and the agency problem in the company.

Question 2 – Long term finance: Equity finance

(a) Lebel plc generates earnings after tax (PAT) of 20 percent on shareholders’ funds. Its current capital structure is as follows:

Ordinary shares of 50p each £300,000

Reserves                                     £ 400,000

                                                     £ 700,000

The board of Lebel plc wishes to raise £180,000 from a right issue in order to expand existing operations. Its return on shareholders’ funds will be unchanged. The current ex-dividend market price of Lebel plc is £1.90. Three different rights issue prices have been suggested by the finance director: £1.80, £1.60 and£1.40.

(b) Identify the:

1. number of shares to be 
2. theoretical ex-rights price.
3. expected earnings per share and
4. form of the issue for each rights issue price, and
5. produce your results in a tabular format and analyze the best option among the three right 

(c) It has become common for companies to offer their shareholders a choice between a cash dividend and an equivalent scrip dividend. Identify the advantages of scrip dividends from the point of view of the company and the shareholders.

Question 3 Investment Appraisal Techniques

Lovewell Limited identifies as the food manufacturer and is considering purchasing a new machine for£275,000. The company is expecting an annual cash inflow of £85,000 from the sale of products and an annual cash outflow of £12,500 for each of the six years of the machine’s useful life. The annual cash outflows do not include annual depreciation charges for the machine. The machine is depreciated using the straight–line method. The machine is expected to last for six years, with a residual value estimated to be at the rate of 15% of the original cost of the machine. The cost of capital for Lovewell Limited is 12%.

Also, provide:

(a) Calculate using the following investment appraisal techniques, and provide brief recommendations as to the economic feasibility of acquiring the machine:

• payback 
• accounting Rate of 
• TheNet Present 
• internal Rate of Return (to two decimal places)

(b) Analyse the benefits and limitations of each of the different investment appraisal techniques and support your answer with academic research.

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