Question 3

AXL Holdings is a group of companies with diversified businesses. Currently, one of its subsidiary is able to secure a government project. Thus, to finance for new machinery and equipment, the management has decided to issue and sells 500,000 units of new common shares at its par value of $5 each with a cost paid to the underwriter at 3% from the selling price. The balance of the capital amount is raised using 1,000, 8% bonds at its par value of $1,000 each. You, as a finance executive, were asked to compute the weighted average cost of capital (WACC) for AXL Holdings considering the following information:

The bond has a maturity period of 20 years with the yield to maturity of 10.5%. The country of the AXL Holdings engaging practising a tax rate of 34%.

AXL Holdings experience a growth of 12% in the past years, but due to unconvincing economy currently, the finance department has projected a much lower growth rate, which is at 8%. In addition, AXL has paid a dividend rate of around 10% to the existing common shares and this new issues is expecting to have a dividend of around the same rate.

a) Determine the WACC for AXL Holdings considering the Book Value Method for capital structure weightage. (7 marks)

b) Retained earnings is one type of internally generated funds. Discuss any THREE (3) reasons why may companies choose to retained earnings rather than issuing new shares or bonds. (6 marks)

To purchase the machinery and equipment stated above, AXL Holdings is valuing two mutually exclusive proposals. The machine and equipment are expected to increase the efficiency of AXL production. The initial cost for proposal A and proposal B are $1,800,000 and $1,400,000 respectively. No scrap value is expected from the machine use and the net after-tax cash flows are presented in the table below: Estimated annual cash flow ($) Year Project A Project B 1 631,500 489,100 2 748,300 735,500 3 804,800 835,200 4 657,300 603,100 5 618,200 NIL FIN2102 (F) / Page 5 of 9 You are require to:

c) Compute the Internal Rate of Return (IRR) and net present value (NPV) for both proposals and recommend which proposal should be chosen. Justify your answer. (10 marks)

d) Explain why many evaluating capital investment opportunities techniques are based on cash flows rather than accounting profits shown in the income statement. (5 marks)