Mopani Ltd. buys, process and freeze dries, Mopani worms for consumption using a variety of industrial packaging techniques. The company has been successful, but, when the company was young, it borrowed heavily at a high rate. It is now considering two capital structures. The two options the company needs to choose from is as follows:

1. Refinance its debt at a lower cost
2. Issue equity and retire its debt

The management has decided that it will only do one or the other.

a) Considering the above information, if the debt capital structure leads to a WACC of 13% while the equity structure leads to a WACC of 15% and the decision is made based purely on the basis of financial risk involved, which capital structure would you recommend the company take?

Assume the company wishes to minimise its financial risk.

Choose the most correct answer.

• A. Issue equity because debt is the source of financial risk
• B. Refinance its debt, a lower interest payment will lower the risk involved
• C. Neither, the financial risk will remain unchanged either way

b) One of the managers of Mopani Ltd. noted that a recent internal report valued the company at a discount of 30% relative to its market price.

Choosing the equity option based primarily on this discount (the difference between the internal valuation and the market price) is an example of which of the following theories?

• A. Market timing theory
• B. Trade-off theory
• C. M&M propositions
• D. Pecking order theory

c) Suppose that the WACC under the debt refinancing option would be 13% and if the company were to issue equity to retire its debt that its WACC would be 15%.

Further to this, assume that the ROE would be higher under the debt refinancing option while the companys beta would also be higher under this option. The net profit of the company is however higher under the equity issue option.

Which of the two options would you choose?

A. Debt refinancing

B. Equity issue

d) Blooms Ltd. management recently reported adhering to a target capital structure. The company has the following target: a debt ratio of 50%. The book debt ratio is however 20% on total assets of R1 million. If the company recently had net profits of R50 000, what was is the companys ROE?

• A. 10.00%
• B. 6.25%
• C. 12.25%