Question 1

(8) Farmers Alliance Limited is considering investing in new equipment with the initial cost

of project/investment to be $100,000. This project is expected to generate EBIT of

S15,000 per year forever (perpetuity). This project or investment can be financed either

with $100.000 in equity (assume from internally generated fund) or with $40.000 of debt

and $60,000 equity. The shareholders required return on an all equity financed project in

This risk class is 106. The firm's marginal tax rate is 40%. The cost of any debt is 5%

before taxes. Note that in the world of Modigliani & Miller, all cash flows are perpetual

and debt does not mature.

Required:

If the project is financed entirely by equity, how much would be its net

worth?

(5 marks)

(i)

What is the adjusted net worth of the project?

(5 marks)

Use the weighted average cost of capital method to value the project.

What is the value of equity? What is the value of debt?

(10 marks)

(iv) Use the flow to equity method to calculate the value of the project's net

worth to equity holders.

(S marks)

(v)

Compare and contrast the strengths and weaknesses of the adjusted present

value, weighted average cost of capital, and flow to equity approaches to

investment appraisal. Which method, in your opinion, is the best? Explain.

(200 words max)

(9 marks)

(6) When a firm raises funds through external debt or equity, it must incur issue costs (in

contradiction to the Modigliani & Miller theorem). Introducing gearing or leverage increases (1)

firm value due to tax benefits (M&M, 1963), (2) cost of equity as a result of sharcholders

exposure to financial distress risk (M&M, 1958) and (3) cost of debt due to bankruptcy risk or

firm's probability of failure.

Required:

(i)

(u)

Explain the effect of issuance cost on firm value.

(2 marks)

Evaluate the effect of gearing on cost of capital and firm value taking into

consideration the three issues above.

(9 marks)

Discuss when and how to use the WACC as a discount rate for valuation.

(5 marks)

(i, ii, & ili should not exceed 300 words)

If

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