Abosky ltd, is a new firm, and has the opportunity to invest in its first new project.
Question:
Abosky ltd, is a new firm, and has the opportunity to invest in its first new project. The new project will require investment of GHS100,000, and is expected to provide net cash flow of GHS40,000 per annum for the foreseeable future (that is, it can be treated as a perpetuity). The board are discussing the best way to raise finance for the new project.
A heated discussion follows. One board member has just been on a course on Miller-Modigliani, and announces that "it does not matter how we finance the project. It will not affect the value of our company. What matters is that the project has a positive NPV at a discount rate of 15%. Therefore, we should take it with any financing mix."
Another board member disagrees. He argues "The financing mix does matter! It is crucial that we find the right capital structure, especially as we pay corporation tax of 40%."
Further Information:
The finance director has obtained two possible estimates of the pre-tax cost of capital for different capital structures as follows (for simplicity, assume that the pre tax and post tax cost of equity is identical);
Case 1: Risk free Debt.
Required:-
a) You are required to prepare a numerical analysis for the board regarding the effect of capital structure on Abosky's cost of capital and firm value. You should analyse 4 cases: a) risk-free debt without tax. b) Risky-debt without tax. c) Risk-free debt with tax. d) Risky debt with tax. In each case, you should present tables, and graphs, that show the WACC and project values for different debt-equity ratios. Your report should recommend the optimal capital structure for the new project in all cases.
Managerial economics applications strategy and tactics
ISBN: 978-1439079232
12th Edition
Authors: James r. mcguigan, R. Charles Moyer, frederick h. deb harris