Question 2

A relatively young firm has capital components valued at book and market price.

No new financial securities have been issued since the firm was originally

capitalized.

Component: Debt

Market value: $42,830

Book value: $40,000

Cost of capital: 8.5%

Component: Preference share

Market value: $10,650

Book value: $10,000

Cost of capital: 10.6%

Component: Ordinary share

Market value: $65,740

Book value: $32,000

Cost of capital: 25.3%

(a) Required:

(i) Calculate the firm's capital structure (Weighted average cost of capital)

based on both book and market values. (8 marks)

(ii) Discuss the increase or fall of market interest rate since the firm

commenced its business. (2 marks)

(iii) Is the firm successful in creating shareholders' wealth (2 marks)

(iv) Discuss one drawback board of directors makes if using book valued

weighted average cost of capital (2 marks)

(b) Discuss 2 reasons why companies calculate a weighted average cost of capital

for use in capital investment project appraisal. (4 marks)

(c) Discuss 3 advantages and 1 disadvantage of debt financing for the firm.

(2 marks)