QUESTION ONE:

A) Explain the Logic of using the Cost of Capital as a discounting rate in Capital Budgeting decisions( Give a good example (5 marks)

B) A Company has a balance sheet whose long-term sources of finance indicates the following:

40,000, 10% debentures 500,000,12% preference shares 4000,000 Ordinary shares Retained earnings

11,000,000 15,000,000 80,000,000 14,000,000

Additional information

1. The current market price of ordinary shares is sh. 60 per share.

2. The company pays tax at the rate of 30%

3. Preference shares are trading at sh.42 per share in the market.

4. The maturity period of debentures is 10 years; the current market price is sh.270 per debenture.

5. The company has a dividend proposal on its ordinary shareholders as follows:

- Interim payment sh.1 per share

- Final payment sh. 2.50 per share.

6.The policy of the company is to grow ordinary dividends at the rate of 4% annually.

Require

The cost of capital based on market values and book values. (25 marks)

C) Suppose the company wants to raise new funds of sh.120,000,000 by issuing the following instruments in the stock market:

10% debentures with floatation costs of sh. 2 per debenture to raise 40,000,000.

12% preference shares with floatation costs of sh. 1.50 per share to raise 20,000,000.

Ordinary shares of sh. 3 flotation costs to raise the balance.

Required:

Find the number of debentures, preference shares and ordinary shares that the company must issue to raise the new funds. (5 marks)

What will be the MCC( marginal cost of capital) based on the new issues

(10 marks)