A company’s long-term capital currently comprises $32 million of debt and $52 mi
ID: 1172379 • Letter: A
Question
A company’s long-term capital currently comprises $32 million of debt and $52 million of equity. Its target capital structure is 40% debt; 60% equity. The company has $4 million of internally-generated funds that can be used to either finance the equity portion of new investments or pay dividends. The company’s weighted average cost of capital is 14%. It is considering four investment opportunities, for which the required investment outlays and expected internal rates of return are shown below:
Project
Investment cost ($’000)
Internal rate of return (%)
A
1,800
17.50
B
1,000
16.00
C
2,200
14.50
D
2,800
13.65
(a) Which projects should be accepted? A, B & C
(1 mark)
(b) What is the total investment cost of the accepted projects? $5m
(1 mark)
(c) How much of that total investment cost should be funded from (i) new debt, $2m and (ii) existing equity? $3m (Give your answer in dollars.)
(3 marks)
(d) According to the residual dividend theory, what amount (if any) would the company be able to pay out in dividends after funding all accepted investments?
(3 marks)
$1m
(e) After investing in all the accepted projects, raising new debt finance and paying any dividends (as identified in the previous part), prepare a summary of the company’s new capital structure, using the following format (which you should copy into your answer booklet):
(4 marks)
$’000
%
Debt
34,000
40
Equity
51,000
60
Total
85,000
100
Project
Investment cost ($’000)
Internal rate of return (%)
A
1,800
17.50
B
1,000
16.00
C
2,200
14.50
D
2,800
13.65
Explanation / Answer
(a) Since the internal rate of return of projects A, B and C is more than WACC of capital of company, hence projects A, B and C should be accepted. Project D should be rejected since its internal rate of return is less than WACC ot the company.
(b) Total investment cost of the accepted projects will be = 1,800,000 + 1,000,000 + 2,200,000
= $5,000,000
(c) Total funds required for the new projects = $5,000,000
This amount can be arranged through existing equity or by raising new debt. The funds have to be arranged in such a manner that the target capital structure of 40% debt and 60% equity can be maintained.
Internally generated funds are $4,000,000. If whole internally generated funds of $4,000,000 are used in funding of the projects, then $1,000,000 will be arranged by issuing new debt. After funding of new projects, capital structure will apper as under:
Debt = 32,000,000 + 1,000,000
= $33,000,000
Equity = 52,000,000
But target capital structure of 40% debt and 60% equity won't be achieved, since debt would be 38.82% and equity would be 61.18%.
Internally generated funds are $4,000,000. If internally generated funds of $3,000,000 are used in funding of the projects, then $2,000,000 will be arranged by issuing new debt. After funding of new projects, capital structure will apper as under:
Debt = 32,000,000 + 2,000,000
= $34,000,000
Equity = 52,000,000 - 1,000,000 (Paid in the form of dividends)
= $51,000,000
Hence, in this way, target capital structure of 40% debt and 60% equity would be achieved.
Hence, total investment in the projects should be funded from $2,000,000 debt and $3,000,000 from existing equity.
(d) Internally generated funds are $4,000,000. Out of this, $3,000,000 would be used in funding of the new projects. Hence residual $1,000,000 would be available for dividend distribution.
(e) Summary of company's new capital structure
Expanation of new debt and new equity has already been given in part (c) above.
$'000 % Debt 34,000 40 Equity 51,000 60 Total 85,000 100Related Questions
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