Zimba plc is a listed, all-equity financed company that makes parts for digital cameras. It is a relatively small operator in a rapidly changing market with high fixed costs. The company pays out all available profits as dividends. Zimba plc has a share capital of 150 million £1 ordinary shares. The company’s cost of equity is currently 15% per annum. The marketing director is proposing a new investment in plant and equipment to manufacture equipment for digital televisions. This would require an initial outlay of £50 million on 30 September 20X0. If the investment was funded by a further issue of shares the annual dividend per share could be increased from 20 to 21p and expected future growth in dividends doubled. 

The new investment is, however, riskier than the average of existing investments, as a result of which the company’s overall cost of equity would increase to 16% per annum were the company to remain all-equity financed. The finance director argues, however, to the contrary: ‘It is nonsense to continue to be all-equity financed. I believe that we could finance the new investment by an issue on 30 September 20X0 of 8% 30-year bonds. Debt would be far cheaper than equity and the interest is available for tax relief.’ The company accountant has reservations: ‘New debt finance would add financial risk on top of the high operating risk caused by the high fixed costs, and this is a particular concern due to the uncertainty of future sales. I believe we should continue to use equity finance, particularly with the additional risk of this new investment. A new share issue would be the best way of doing this.’ The managing director was unsure: ‘I seem to recall that it should not really matter whether we use debt or equity finance. Theoretically, the cost of capital should not be sensitive to changes in the capital structure, so it shouldn’t matter how we finance the project.’ 

Required 

As Zimba’s newly recruited management accountant, you have been asked to write a report to the directors which, so far as the information permits, advises them on: 

The potential implications of the new investment Financing options currently being discussed, including an analysis of the concerns expressed by the directors and the company accountant the potential advantages and disadvantages of at least two alternative sources of finance for the new investment. Note that you are not expected to undertake any calculations in support of your analysis of the issues.