Financial Management: Cost of Capital and Investment Decisions

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Financial Management
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Table of Contents
Introduction......................................................................................................................................3
Question 1........................................................................................................................................4
A......................................................................................................................................................4
B.......................................................................................................................................................6
C.......................................................................................................................................................8
D......................................................................................................................................................9
Question 3......................................................................................................................................10
A....................................................................................................................................................10
B.....................................................................................................................................................13
Conclusion.....................................................................................................................................16
References......................................................................................................................................17
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Introduction
The given assessment is based on the financial management. It consists of 3 numerical questions.
Question 1 is based on the cost of capital of the company and capital structure theory based.
Capital structure consists of equity shareholders fund, reserve and surplus, debenture and
preference shareholders and loans. It helps in finding overall cost of capital of the firm so that the
decision can be taken that the capital structure of the company is favorable or not. Question 2 is
based on the financing decision such as long term financing as equity capital. Question 3 is based
on the investment decision as there are various investment methods for taking decision such as
based on Net Present Value, Internal Rate of Return, Payback Period and Accounting Rate of
Return. All these investment have their own techniques to calculate the investment decision.
NPV is helps in the decision based on the present value of the given factor. Payback period
should the time period for the amount is paid.
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Question 1
A
Given That
Particulars Book Value Market Value
Ordinary Shares 20,000,000 20,000,000
Ordinary Shares Price £ 1 £ 2.65
Reserves 5,000,000 5,000,000
7% preference Shares 10,000,000 10,000,000
Preference Shares Price £ 1 £ 0.75
10% Irredeemable Bonds 150,000 150,000
Bond Price £ 100 £ 107
Tax Rate 30% 30%
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Calculation of Growth Rate:
Year Dividend Growth
1 0.21 -
2 0.23 9.52%
3 0.25 8.70%
4 0.27 8.00%
5 0.28 3.70%
Average Growth Rate 7.48%
Calculation of Weighted Average Cost of Capital (Book Value):
Particulars Book Value Weights Costs Weighted
Average Costs
Cost of Equity Shares £ 25,000,000 0.50 37.57% 18.79%
Cost of Preference Shares £ 10,000,000 0.20 7% 1.40%
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Cost of Debt £ 15,000,000 0.30 7% 2.10%
Weighted Average Cost of
Capital £ 50,000,000 22.29%
Calculation of Weighted Average Cost of Capital (Market Value):
Particulars Market Value Weights Costs Weighted
Average Costs
Cost of Equity Shares £ 58,000,000 0.7112 18.84% 13.40%
Cost of Preference Shares £ 7,500,000 0.0920 9.33% 0.86%
Cost of Debt £ 16,050,000 0.1968 6.54% 1.29%
Weighted Average Cost of
Capital £ 81,550,000 15.54%
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B
Given that:
Particulars Book Value Market Value
Ordinary Shares 20,000,000 15,578,702
Ordinary Shares Price £ 1 £ 2.85
Reserves 5,000,000 5,000,000
7% preference Shares 10,000,000 10,000,000
Preference Shares Price £ 1 £ 0.68
10% Irredeemable Bonds 150,000 150,000
10% Irredeemable Bonds Price £ 100 £ 107
11% Bonds 150,000 150,000
11% Bonds Price £ 100 £ 84
Tax Rate 30% 30%
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Calculation of New Growth:
Particulars Rate
Original rate 7.48%
Current Year's Dividend £ 0.28
Growth £ 0.02
Increase in growth rate 20%
New growth in relative terms £ 0.03
Next Year's Dividend £ 0.31
Calculation of Weighted Average Cost of Capital (Market Value):
Particulars Market Value Weights Costs Weighted
Average Costs
Cost of Equity Shares £
49,399,300 0.58 18.19% 10.59%
Cost of Preference
Shares
£
6,800,000 0.08 10.29% 0.82%
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Cost of Debt (10%
Irredeemable Bonds)
£
16,050,000 0.19 6.54% 1.24%
Cost of Debt (11%
Bonds)
£
12,600,700 0.15 9.17% 1.36%
Weighted Average Cost
of Capital
£
84,850,000 14.01%
As the change in the capital structure leads to change in the weighted average cost of capital.
Change in the capital structure such as the change in equity or debenture or their respective costs.
The company wants to keep their capital structure as a perfect combination so that the weighted
average cost of capital can be minimized. A perfect ratio of debt and equity should be in the ratio
of 2:1. It is the ideal ratio of the capital structure. The change in the capital results in the change
in their weighed average as well their cost of capital will also change which finally effects the
change in the WACC of the company(Chittenden, and Derregia, 2015).
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C
Yes the company can able to minimize their weighted average cost of capital by merging the
capital structure and capital gearing ratio. As the capital gearing ratio is the ratio that helps in
analyzing the capital structure of the company and also able to make a perfect capital structure so
that the over cost of capital can be minimized. It is calculated by dividing the stockholders equity
with the fixed interest or fixed cost bearing fund. It also helps in analyzing the fund by
measuring the relationship of the funds that is been provided by the common equity stockholders
with the fixed interest rate or a dividend rate(Chittenden, and Derregia, 2015).
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D
1 Financial Effect: - usually the bankruptcy is also a mixed blessing which means if creates both
favorable as well as unfavorable effects. They can future be classified into long term or short
term
Short-term effects: - it effects that the creditors will getting insolvent and the company
is getting the loss as the it is difficult to recover the liability from the creditors as they are unable
to pay because of unavailability of the fund with them and they don’t have that much capability
to repay their liability or to reduce their liability(Chittenden, and Derregia, 2015).
Long-Term effects: - it shows the information after the bankrupt has been completed. It
is very critical situation when if an individual want to buy a car and half of the amount has been
paid as down payment then also the company is not giving the credit due to the risk of
insolvency which creates a loss to the company (Baker, and Wurgler, 2015).
2 Emotional Effects: -
Yourself: - it is based on the self-emotions as there is lack of honesty and self-respect.
The feeling also emerges because it is difficult to manage all the affairs smartly and unable to
handle the problems as lank of money management. The dishonesty feeling is arises the
individual of the company is cheating to their creditors only. Some individual understand the
value of the creditors but some cannot and cannot overcome from the situation so that they
follow the same pattern of cheating to their creditors (Heydt, 2017).
Family and Friends: - it also provide the effects of the family as an individual is also
cheating its family as after a certain period of time the family is able to know about them
regarding the bankruptcy. The main thing is to understand the sympathy and also the value of the
family in their own life.
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