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$ Clients Investments: (40 marks) 1. Douwe Ltd. is a logistics company with the following balance sheet: Long-term debt Bonds: Par $100, annual coupon 7% p.a., 3 years to maturity Equity Preference shares Ordinary shares Total 3,000,000 1,000,000 6,000,000 10,000,000 I Notes: The company's bank has advised that the interest rate on any new debt finance provided for the projects would be 8.5% p.a. if the debt issue is of similar risk and of the same time to maturity and coupon rate. There are currently 500,000 preference shares on issue, which pay a dividend of $0.17 per year. The preference shares currently sell for $2.50. The company's existing 6,000,000 ordinary shares currently sell for $0.95 each and management has disclosed that it expects to pay a dividend of 5 cents per share at the end of the next year. Historically dividends have increased at an annual rate of 7% p.a. and are expected to continue to do so in the future. The company's tax rate is 30%. Your client wishes to understand, with the use of workings, the following aspects of this company and states that their required rate of return for the investment in a company with similar characteristics to Douwe would be 12% pa Advise the client on whether you believe this to be a good or bad investment and the rationale for investment (or not investing). a) What are the assumptions underlying the use of a dividend growth model for the estimation of a company's cost of equity? b) Determine the market value proportions of debt, preference shares and ordinary equity comprising the company's capital structure. c) Calculate the after-tax costs of capital for each source of finance. d) Determine the after-tax weighted average cost of capital for the company. e) Under what conditions can the firm's weighted average cost of capital be used for assessing new projects? f) Provide recommendation to your client. (14 marks) 2. Your client is evaluating two mutually exclusive projects, X and Y. The cost of capital is 12%, and expected cash flows of the two projects are as follows: 0 1 2 3 4 5 Year Project X Project Y -$1,200 -$1,200 250 320 290 500 460 450 470 270 510 260 What is the payback period of the better project? (8 marks) 3. A firm that your client would like to invest is only accepts projects providing an IRR more than 15%. The company is evaluating an eight-year project that requires $74,515 in initial investment and provides $15,000 in annual net cash inflows. (a) What is the IRR of the project? Is it acceptable? (b) Assuming the annual net cash inflows continue to be $15,000, how many additional years would the flows continue in order to make the project acceptable (that is, to have an IRR of 15%? (c) With the given project life (8 years) and initial investment, what is the minimum annual net cash inflows in order to make the project acceptable? (8 marks) 4. Your client is considering investing in one of the two Treasury bonds which have a face value of $100,000 and pay coupons at the rate of 10% semi-annually. Bond P has four years to maturity and bond Q has eight years to maturity. Your client would like to know: (a) If the current interest rate is 7.5% p.a., what are the prices of the two bonds? (b) If the interest rate rises to 12% p.a., what are the prices of the two bonds? (c) What are the observations can be made based on these results
