Question 1

Nelson Corporation has made the following forecast of sales, with associated probabilities of occurrence noted.

Sales: Probability:

200000 20%

300000 80%

The company has fixed operating costs of R100,000 per year, and variable operating costs (cost of sales) represent 40% of sales. The existing capital structure consists of 25,000 shares and share price is R10 per share (this means the total value is R250000 (25000*20)). There is not debt in this capital structure

The company is contemplating shifting its capital structure by substituting debt in the capital structure for common stock. The two different debt ratios under consideration are shown in the following table, along with an estimate, for each ratio, of the corresponding required interest rate on all debt.

Debt Ratio: Interest rate on debt:

20% 10%

40% 12%

The Tax rate is 40%

a.Calculate the expected EPS, for no debt capital structure, and for 20% and 40% debt

b.Determine the optimal capital structure for all three structures, using EPS maximisation approach and share value maximisation approach (12% as cost of capital)

Question 2

A firm has determined its optimal structure which is composed of

the following sources and target market value

proportions.

Source of Capital: Target Market Preposition:

Long- Term debt 60%

Common Stock equity 40%

Debt:

The firm can sell a 15-year, R1,000 par value, 8 percent bond for R1,050. A

flotation cost of 2 percent of the face value would be required in addition to

the premium of R50.

Common Stock: A firm's common stock is currently selling for

R75 per share. The dividend expected to be paid at the end of the coming year

is R5. Its dividend payments have been growing at a constant rate for the last

five years. Five years ago, the dividend was R3.10. It is expected that to

sell, a new common stock issue must be underpriced R2 per share and the firm

must pay R1 per share in flotation costs. Additionally, the firm has a marginal

tax rate of 40 percent.

Required

Calculate the Weighted Average Cost of Capital.