CLASSIC TUTORS

ILLUSTRATIVE
QUESTIONS
(WEEK 1)
15-17 FEBRUARY 2017
 1. You are given the following details:
N
Sales 50,000,000
Variable costs 20,000,000
Contribution 30,000,000
Fixed operating costs 10,000,000
EBIT 20,000,000
Interest 5,000,000
Earnings before tax 15,000,000
Tax at 40% 6,000,000
PAT 9,000,000

Required:
a) At the current level of output, what is the DOL?
b) What is the DFL?
c) What is the CL?
d) If sales should increase by 20%, by what percent would PAT increase.

2. Ogbodu Nigerai Plc is planning to expend NGN10million on an existing project. It

has been suggected that the finance could be raised by through the issue of 9%
bond, redeemable in 10 years' time. Current financial information on the business
is as follows:

Income statement information for last year

N'000
Profit before interest and tax 7,000
Interest (500)
Profit before tax 6,500
Tax (1,950)
PBIT 4,550
Statement of Financial Position
N'000 N'000
Non-current assets 20,000
Current assets 20,000
Total assets 40,000
Equity & liabilities
Ordinary shares, par value N1 5,000

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 Retained earnings 22,500
Total equity 27,500
10% Bonds 5,000
9% Preference shares 2,500
Total non-current liabilities 7,500
Current liabilities 5,000
Total equities and liabilities 40,000

The current ex-div ordinary share price is N4.50 per share. An ordinary dividend
of 35kobo has just been paid and dividends are expected to grow at an annual
rate of 4% for the foreseeable future. The current ex-div preference share price is
currently 76.2kobo. The bonds are secured on the fixed assets of the Company
and are redeemable in 8 years' time at par. The current ex-interest price of the
bond is N105. The company pays income tax on its profits at the rate of 30%.
The proposed expansion is expected to increase profit before interest and tax by
12% in the first year.
The Company has no overdraft facility.

Required:
Determine the appropriate Cost of Capital which the Company should use to
appraise the project.

Evaluate the impact of the bond finance and the business expansion on the
following ratios of the Company:
o Interest coverage ratio
o Financial gearing
o Earnings per share

Would you agree with the Financial Management Theory which suggests that the
Average Cost of Capital of a company can be reduced to the minimum level
through debt financing?

3. Emma plans to raise N5million in order to expand its existing chain of retail
outlets. It can raise the finance by issuing 10% bonds redeemable in 2015, or by a
rights issue at N4 per share. The current financial statements are as follows:

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 Profit and loss account for the year N00
Sales 50,000
Cost of sales 30,000
Gross profit 20,000
Admin. Costs 14,000
EBIT 6,000
Interest 300
Profit before tax 5,700
Tax at 30% 1,710
Profit after tax 3,990
Dividends 2,394
Retained earnings 1,596

Balance Sheet N000

Net fixed assets 20,100
Net current assets 4,960
12% debentures (2010) 2,500
22,560
Ordinary shares at 25k 2,500
Retained profit 20,060
22,560
The expansion of the business is expected to increase sales revenue by 12% in the
first year. Variable cost of sales make up 85% of cost of sales. Administration costs
will increase by 5% due to new staff appointments. Ema has a policy of paying
out 60% of profits after tax as dividends and has no overdraft.

Required:
a) For each financing proposal, prepare the forecast profit and loss after one
additional year of operation
b) Evaluate and comment on the effect each financing proposal on the
following:
1) Financial gearing
2) Operational gearing
3) Interest cover
4) Earnings per share
c) Calculate the EBIT that will generate the same EPS, irrespective of the
method of financing

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 d) Discuss the dangers of to a company of a high level of gearing, including in
your answer an explanation of the following terms:
1) Business risk
2) Financial risk

4. Ajoke Nig. Plc is financed by N60m N1 ordinary shares currently valued at 156k
per share. The results of the last five financial years are as follows:

Yr Earnings Dividend
20x4 N20m N15.6m
20x3 N18m N15m
20x2 N16m N13.2m
20x1 N15.4m N12.3m
20x0 N13.9m N11.1m
Calculate the cost of the company's capital.

5. Pedro Plc. and Bariga Plc. are two companies in the same line of business, with the
same level of risk and having the same profit before interest. Pedro Plc. is entirely
equity financed with 2,000,000 -25k ordinary shares currently quoted at N1.20
ex-div.
Bariga plc. is a geared company with 1,250,000 -25k ordinary shares with market
value of N1.00 ex-div and N1,500,000 of 10% irredeemable loan stock currently
quoted at par.
Both companies generate an annual profit before interest of N360,000, all profit
after interest is distributed as a dividend.
Mr Shomolu owns 65,500 shares in Bariga plc. A friend, Mr Tinubu, has
recommended he sells these shares, borrows sufficient funds at a rate of 10% and
to use the proceeds to buy ordinary shares in Pedro plc.
You are required to:
a) Calculate the cost of equity and weighted average cost of capital of each
company:
b) Advise Mr shomolu as whether his proposed transaction is worthwhile
both from the point of view of increased income and considering the level
of associated uncertainty.

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 c) Calculate the prices of the ordinary shares of Kaiama plc. which would
produce no gain to Mr Shomolu on switching funds assuming all other
prices remain firm.
d) Calculate the cost of equity and weighted average cost of capital of each
firm at the above equilibrium price.
e) What reservation do you have about the manner in which Shomolu has
been advised to switch investments from Bariga to Pedro.

6. What is the cost of capital for Yola Plc, given the data presented below:
Beta co-efficient 0.5
Expected rate of returns on risk-free securities 8%
Expected return on market portfolio 12%

7. A company's share price is N8.20. The company has just paid an annual dividend
of N0.70 per share, and the dividend is expected to grow by 3.5% into the
foreseeable future. The next annual dividend will be paid in one year's time.
What is the company's cost of equity capital?

8. Sunny Ventures is an all-equity financed company. The current market value per
share is N13.00. The most recent dividend has just been paid to its shareholders.
This was N1.50 per share.
Required
Estimate the cost of equity in this company in each of the following circumstances:

a) Using the DVM and when the annual dividend is expected to remain
constant into the foreseeable future.
b) Using the DVM and when the annual dividend is expected to grow by 4%
each year into the foreseeable future.
c) The CAPM is used, the equity beta is 1.20, the risk-free cost of capital is
15% and the expected market return is 14%.

9. An all-equity company has a market value of #150 million and a cost of equity of
10%. It borrows #50 million of debt finance, costing 6%, and uses this to buy
back and cancel #50 milliom of equity. Tax relief on debt interest is ignored.
Required:

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 According to Modigilani and Miller, if taxation is ignored, what would be the
effect of the higher gearing on
a) The WACC
b) The total market value of the company: and
c) The cost of equity in the company.
10. A company has #500 million of equity capital and #100 million of debt capital, all
at current market value. The cost of equity is 14% and the cost of the debt capital
is 8%.
The company is planning to raise #100 million by issuing new shares. It will use
the money to redeem all the debt capital.
Required
According to Modigilani and Miller, if the company issues new equity and
redeems all its debt capital, what will be the cost of equity of the company after
the debt as been redeems?

11. The coupon rate of interest on an irredeemable bond is 6%, while the current
market value of the debt is N103.60. The corporation tax rate is 25%.

a) What is the pre-tax cost of the bond?

b) What is the after-tax cost of the bond?

12. A company has N10,000 of debt at 10% interest rate, and earns N10,000 a year
before interest is paid. There are 4,500 issued shares, and the WACC is 20%.
Requirements:
a) 1. What is the company's market value?
2. What is the cost of its equity?
3. What is the market value of its equity?
b) Suppose the company issues N10,000 additional debt at 10% interest to
repurchase shares at the price calculated in (3) above. If the WACC remains
unchanged;
1) Calculate the number of shares that were repurchased?
2) What is the new cost of equity capital?
3) What is the new market value per share?

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 13. An all-equity company has a market value of #50 million and a cost of equity of
8%. It borrows #20 million of debt finance, costing 5%, and uses this to buy back
and cancel #20 million of equity. The rate of taxation on company profit is 25%.

14. Ademola Ltd is a machine tools company with the following capital structure as at
31st December 2007.
N
Ordinary shares of N1 500,000
Capital reserves 400,000
Revenue reserves 600,000
1,500,000
9% Perpetual bonds 400,000
15% Perpetual bonds 600,000
2,500,000

The current yield on bonds of the same risk class is 12%. The current price is 550k
and earnings per share are 110k.
The company is considering an expansion plan which will cost N1,000,000 and
which will increase earnings by N200,000 per annum for the foreseeable future.
There are two possible ways to raise the funds required:
I. An issue of 12% bonds which will increase the return required by
shareholders to 22% to compensate for higher risk due to the increased
gearing, or
II. An issue of 200,000 new shares at 500k to a consortium of institutions.
This will reduce the return required by shareholders to 19% because of the
reduction in gearing.
Required:

a) Calculate the capital gearing of the company as at 31st December 2007

using the book value approach
b) Calculate the capital gearing of the company as at 31st December 2007
using the market value approach
c) Explain why the market value approach is superior
d) Calculate the capital gearing of the company after the issue of 12% bonds
using market value approach
e) Calculate the capital gearing of the company after the issue of 200,000
ordinary shares using the market value approach

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 f) Explain how preference shares should be treated in the calculation of
capital gearing
g) Explain how bank overdrafts should be treated in the calculation of capital
gearing.
15. The current market value of a company's 7% bond is 96.25. The annual interest
has just been paid. The debt will be redeemed at par after four years.
The rate of taxation on company's profits is 30%.
What is the after-tax cost of the debt?
16. Lanre owns 1% of the equity of Lubileye plc. an ungeared company. A friend
Tawa, recommends that Lanre switch his funds to a similar but geared company,
Lekenka plc. in order to maintain the risk associated with each investment, it is
suggested that Lanre buys 1% of the equity of Lekenka plc and invest his
remaining funds in Lekenka plc and invest his remaining capital structures are as
shown below:
Lekenka plc Lebileye plc
N N
N1 ordinary shares: Nominal value 200,000 300,000
Market value 125,000 250,000
5% Debenture: Nominal value 100,000 -
Market value 100,000 -
Profit before debenture interest 25,000 25,000
Annual dividend 20,000 25,000
Debenture interest 5,000 -
a) Calculate Lanres present income from Lubileye plc
b) Calculate his income on switching his funds, in the manner described, to
Lekenka plc.
c) Calculate the price of Lekenka plcs equity at which it would no longer pay
Lanre to switch his funds, assuming no other prices moved.
d) Calculate the two companies costs of equity and average costs of capital at
the prices found in {c}.
e) Comment on the various calculations required above.
17. Jimoh owns 1% of the equity of Aristo plc a geared company with 1 million N1
ordinary shares having a market value of #1.10 per shares and #600,000 10%
debentures valued at N80. Shola who is a friend of Jimoh has recommended that
Jimoh transfer his funds to Jezebel plc. an ungeared company. Both firms are in
the same type of business susceptible to the same degree of business risk and both
firm generate income before debenture interest of N200,000.

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 Jezebel plc is financed by 1.2million N1 ordinary shares with a market value of
N1.05per share.
The way in which it is recommended that Jimoh transfer his fund and still
maintain the same risk position is as follows. On selling his shares in Aristo plc he
should borrow sufficient funds in order to buy 1% of Jezebel plc.
You are Required to calculate:
a) Jimohs present income from Aristo plc.
b) His income on switching funds to Jezebel plc.
c) The gain to Jimoh on switching
d) The equilibrium position {assuming only Jezebel plc equity changes in
value}.

18. A US company has a total market value of #12 billion considering of #10billion of
equity and #2billion of debt capital. The debt capital will mature in four years
time. The current weighted average cost of capital is 6.5%.
The company considering a new investment costing #3billion, which it would
finance entirely by #3billion of new ten-year bonds.
The yield curve for US government bonds {treasures} shows that the risk-free cost
of four-year debt is 4% and the risk free cost of ten year debt is 4.25% .the credit
rating on the companys debt capital is AA. But if the new bond issue takes place
there is a75% probability that all the companys debt will be rerated to AA- and a
25% probability that all the companys debt will be rerated to A+(this applies to
both the existing debt and the new bonds.)
The spreads for yields on corporate bonds above the US Treasures yield curve are
as follows:
Credit rating Spreads (basis points)
4-Year Bonds 10-year Bonds
AA 30 50
AA- 40 60
A+ 45 70
The rate of taxation on company profits is 30%

Required
Calculate the weighted average cost of capital in the company if the project goes
ahead and is financed entirely by ten year bonds. Assume that there will be no
changes in the companys business risk

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 19. Dantata Plc has in issue 4% convertible bonds that can be converted into shares in
two years' time at the rate of 25 shares for every N100 of bonds. It is expected
that the share price in two years' time will be N4.25.
If the bonds are not converted, they will be redeemed at par after four years.
The yield required by investors in these convertibles is 6%.
What is the value of the convertible bonds?

20. Honey Comb Plc has issued 10% convertible loan stock which is due for
redemption in 10 years' time i.e December 31, 2025. The option to convert is
open for another 2 years. If conversion does not take place by December 31,
2017, the option will lapse. The issue was sold to the public at a price of N920 for
N1,000 of convertible loan stock. The conversion rate at January 1, 2016 was 250
equity shares for N1,000 of stock. Non-convertible loan stock in a similar risk class
is presently yielding 12%. The market price of Honey Comb Plc. Equity shares has
been increasing steadily over time reflecting the performance of the company. The
shares currently pay a dividend of N0.30 per share. The current price of the
convertible security is N960 and each share is currently valued at N3.00. A holder
of the convertible loan stock is considering whether to sell his holdings or
continue to hold onto it.
Required:
a) What is the value of the security as a simple unconvertible loan stock?
b) What is the expected minimum annual rate of growth in the equity share
price that is required to justify the holder of convertible loan stock holding
onto the security before the option expires?
c) What recommendation would you make to the holder of the security and
why?
21. The issued share and debt capital of Kole Plc is as follows:

N
N1 ordinary shares 250,000,000
12% N1 preference shares 50,000,000
6% convertible bond 75,000,000
8% unsecured loan stock 150,000,000
The ordinary shares have a current market price of N3 each. The dividend for
2006 of 33.3kobo per share has just been paid. Dividends per share in the four
preceding years were as follows: 2002 24.5k 2003 26.4k 2004 28.5k 2005
30.8k.

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 Dividends are paid once a year and are expected to grow in future at the same
annual rate as they have since 2002.
The preference shares have a market price of N0.80 each. The 2006 dividend of
12 kobo per share has just been paid. Dividends on the preference shares are paid
once per year. The convertible bond has a market price of N120%. The stock is
convertible into ordinary shares in four years' time at a rate of N100 nominal of
stock for 37 ordinary shares. The market price of the shares at the time of
conversion is expected to be N4.08 each. If not converted, the stock will be
redeemed in four years' time at a price of N125%.
The unsecured loan stock has a market price of N80% and is redeemable at par in
five years' time. Interest on both the convertible loan stock and the unsecured
loan stock is paid annually. The company has just paid the interest for 2007 on
both. The company pays corporate tax at a rate of 25%.
Required:
a) Estimate the weighted average cost of capital for the company
b) Discuss the arguments for and against the use of WACC as a discount rate for
investment appraisal
Note: For part (a) only, assume that tax savings arise in the same year as the debt
interest payments to which they relate.

22. Dividends Valuation Model and Capital Asset Pricing Model are two important
models used to estimate cost of equity capital.
Required: Discuss, in sufficient details, why the two models may not necessarily
produce the same estimate of cost of equity capital. Express your opinion as to
which of the two models is likely to provide the more reliable figure.

CD plc has the following summarized capital structure as at December 2006.

Nm
Net assets 740
Financed by:
Issued ordinary shares (25 kobo par value) 120
Reserves 270
12% bonds redeemable at par of N100 in 13 years' time 200
Bank floating rate term loans 150
740

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 The ordinary shares are currently trading at 345 kobo per share, and the
debentures at N114.
The company believes that it can issue new long-dated debentures at gross yield
of 3% above the risk-free rate. The systematic risk of the group's shares is 80% of
the market and the market return is estimated to be 15%. Corporate tax is 30%.
The current level of inflation is 3.85% per year and this is expected to continue
for the foreseeable future.
Required
Estimate the real WACC of the company.

23. Tinko Plc repairs and maintains heavy-duty trucks with workshops all over Nigeria
and a number of countries in Africa.
Below are extracts from the most recent Statement of Financial Position of TP:

Nmillion

Share capital (50kobo/share) 200

Reserves 320

Non-current liabilities 760

Current liabilities 60

1,340

TP's Free Cash Flows to Equity (FCFE) is currently estimated at N153million and
this is expected to grow at 2.5% per annum to infinity. The equity shareholders
require a return of 11%.

The Company's non-current liabilities consist entirely of N1,000 nominal value of

bonds which are redeemable in four years' time at par, with a coupon rate of
interest of 5.4%. The debt is rated BB and the credit spread on BB is 80 basis
points above the risk-free rate of return.

The government recently launched its ''Graduates Back To Land (GBTL)''

programme in which graduates are being encouraged to take on highly
mechanized farming. The programme will involve massive importation of heavy-
duty agricultural machines like tractors, harvesters, driers, etc. for distribution to
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 ''Graduate Agric Clubs'' all over the country. However, there is a growing concern,
within the countryabout the possibility of effective maintenance of these
machines. TP is therefore considering entering this market through a four-year
project. The project will cease after four years because of increasing competition.
The initial cost of the project is expected to be N84million and it is expected to
generate the following after-tax cash flows over its four-year life.
Year 1 2 3 4
Cash flows (N000) 5,555.20 32,268.60 73,009.40 71,367.20

The above figures are based on the GBTL programme growing as expected.
However it is estimated that there is 25% probability that the GBTL programme
will not grow as expected in the first year. If this happens, then the present value
of the project will be 50% of the original estimates over its four-year life.

It is also estimated that the GBTL programme grows as expected in the first year,
there is still a 20% probability that the expected rate of growth will slow down in
the second and subsequent years, and the present value of the project cash flows
would then be 40% of the original estimates in each of these years.

Feedwell Limited (FL) has offered N100million to buy the project from TP at the
start of the second year. TP is considering whether having this choice would add
value to the project.

Although, there is no beta for companies offering maintenance services for only
agricultural machines and equipment in the country. Abako Plc (AP), a listed
company, offers maintenance and related services for construction, mining and
agricultural equipment. About 15% of its business is in the equipment maintenance
services in the agricultural sector. AP has an equity beta of 1.6. It is estimated that
the asset beta of non-agricultural maintenance sector is 0.8. AP's shares are
currently trading at N4.50 per share and its debt is currently trading at N1,050 per
N1,000. It has 80million shares in issue and the book value of its debt is
N340million. The debt beta is estimated to be zero.

The income tax rate applicable to all companies is 20%. The risk-free rate is
estimated to be 4% and the market risk premium is estimated to be 6%.

Required:

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 a) Calculate the current total market value of TP's:
i. Equity
ii. Bonds
b) Calculate the risk-adjusted cost of capital required for the new project.
(Round your final answer to the nearest %)
c) Estimate the value of the project with and without the offer from FL
d) State the assumptions made in your calculations

24. The summarized Balance Sheet of Bark and Bate is as follows:

N N
Ordinary share capital 750,000 Fixed Assets 1,400,000
Reserves 400,000 Net Current Assets 100,000
Loan (9%) 300,000
Deferred taxation 50,000 -
1,500,000 1,500,000
The Company believes that the above capital structure is approximately that
which it would wish to maintain.
Two proposals have been placed before the directors, each of which will require
an initial investment of N300,000 and each of which will use the one piece of
vacant land which the company has available so that only one investment can be
chosen.
Project A will generate net cash flows of N120,000 per annum for the first three
years of its life and N50,000 per annum for the remaining two. Project B will
generate net cash flows of N100,000 per annum during its life, which is also five
years. Neither project has any scrap value, but the first is regarded as less risky.
There is N40,000 of internally generated funds available and the remainder will
have to be raised to through the issue of loan stock and/or ordinary shares. The
estimated cost of equity is 15% and an issue of ordinary shares of N5 per share
will result in net proceeds per share of N4.75. Loan stock can be sold at least to
yield 12%. The Company has a marginal corporation tax rate of 50%.
Advise the directors on these projects and the appropriate cost of capital for the
selected project.

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 25. Adele Nigeria Plc is considering raising N100,000 by issuing 10% bonds. At
present, its capital consists entirely of ordinary shares, being 200,000 25k ordinary
shares valued at 40k cum-div and the dividend, which is about to be paid, is 4k.
Dividend has been stable for several years. If the company's level of gearing is
altered, it is felt that the ordinary shareholders will require a rate of return of 15%
with the market value remaining unaltered.
Required
Calculate the marginal cost of the new debenture and the WACC of the company
with its revised capital structure.

26. Corporate Limited has in issue the following securities against each of which details
of their present market standing are given:
Type of Security Nominal Value Market Value Current Yield
Ordinary shares 2m N1 share N1.50 per share 8% per annum
10% pref. shares 1/2m N1 share 90.9k per share 11% per annum
12% bonds N200,000 N120 per cent 10% per annum

The company is considering the raising of extra capital and has been advised by its
merchant banker that the following terms would need to be offered on each type
of security:

a) Ordinary share: Issue price N1.40

Cost of issue 5k per share
b) 10% Preference shares: Issue price 85k
Cost of issue 8k per share
c) 12% Bonds Issue price N115
Cost of issue 1% ofnominal value

27. Spare Limited is an ungeared company with 1.5 million ordinary shares of N1 each
currently valued at N2.40 ex-dividend, the dividend which has been constant for
several years, of N432,000 has just been paid. The company wishes to finance a
new project with an issue of N1.8 million of 7% irredeemable bonds. It is felt that
shareholders will expect their dividend to rise by N36,000 as a result of this
increased gearing.
You are required to find:

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 a) The original cost of equity
b) The new cost of equity
c) The true marginal cost of bonds
d) The new weighted average cost of capital; and
e) The additional dividend required by equity if one is to believe the
Modigliani and Miller view of gearing.

28. Wenco Limited has the following capital structure, which it considers to be
optimal under the present and expected future conditions:
%
Debt 30
Equity 70
100
For the coming year, the Management expects to realize net earnings of
N560,000 plus N350,000 depreciation cash flows. The past dividend policy of
paying out 50% of earnings will continue. The company can borrow at 8%.
Income tax rate is 40%. The current share price is N50 per share. Its last dividend
was N1.85 per share, while the growth rate in share price is N50 per share. Its last
dividend was N1.85 per share and the growth rate in dividend is 8%. External
equity can be issued.
The firm has the following investment opportunities for the next period:
Project Cost IRR
A N500,000 12%
B N150,000 11%
C N200,000 10%
D N500,000 9%
Management asks you to help them determine what projects should be
undertaken.
You proceed with this analysis by following these steps:
a) Calculate the WACC using both retained earnings and new equity
b) Which projects should the firm accept
c) What implicit assumptions about project risk are embodied in this problem?
d) If you learned that projects A and B were above the average risk in the
company, yet the firm chose these projects which you indicated in part (b),
how would this affect the situation?
e) The problem stated that the firm pays out 50% of its earnings as dividends.
How would the analysis change if the pay-out ratio were changed to :

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 I. 0%
II. 100%

29. Adeyemi has a sales volume of 200,000 units with a total fixed costs of
NGN1.2million. Unit selling price is N20 and variable cost per unit is N10. The
company is financed as follows:
N000
Ordinary shares 1,400
18% Preference shares 400
15% Debentures 1,200
The rate of taxation is 40%
Calculate and interpret the DFL.
30. ABC Limited has an equity beta of 1.25. The beta factor of its debt capital is 0.05.
The total market value of the shares of the company is N600m and the total
market value of its debt capital is N200m. The rate of corporation tax is 30%.
Required:
a) Calculate the asset beta of the company
b) Re-calculate the asset beta if the debt capital is risk-free
31. Ayefele is an unlevered company with an equity beta factor of 1.05. The total
market value of the company is N240 million. This includes debt capital with a
market value of N80 million.
It is assumed that the debt capital is risk-free. Corporation tax rate is 30%.
Required
Calculate the asset beta for the company.
(Asset beta formular)
32. A company is considering investing in a new capital project where the business risk
is dissimilar to its normal operations. It is financed by 80% equity and 20% debt.
Its Management has identified the following proxy companies in the target
industry with the following characteristics:

Company Equity Beta Gearing

Ratio

A 1.05 30%

B 1.24 50%

C 1.15 40%

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 The risk-free rate of return is 5% and the market rate of return is 8%. Tax on
company profits is at the rate of 30%.
You are to assume in each case that debt capital is risk-free.
Required:

Calculate a project-specific discount rate for the project, assuming that this is:
a) the project-specific cost of equity for the project; or
b) the weighted average of the project-specific equity cost and the company's
cost of debt capital.
33. Omega Plc., an all-equity-financed company, operating in the an industry where
beta factor is 0.9 is considering investing in a completely different industry.
The average debt/equity ratio in this industry is 40% and the average beta factor
is 1.25.
The risk-free rate of return is 4% and the average market return is 7%. If the
company does not invest in this industry, it will remain all-equity-financed. The
rate of taxation is 30%. Assume that debt is risk-free.
Required
What cost of capital should be used to evaluate the proposed investment?
34. A company has a total current market of N80 million, consisting of N60 million
equity and N20 million of debt capital. The cost of equity in the company is 12%
and the pre-tax cost of debt capital is 7%. The rate of tax on profits is 30%. The
equity beta factor is 0.925. The debt capital is risk-free. The return on the market
portfolio is 13.67%.
Required
What will be the equity beta factor and the cost of equity in the company, if the
company issues new equity to raise N10 million and uses this money to repay N10
million of debt?
35. An investor is interested in acquiring Greenco, which is a private company with
net assets of N240 million and debt capita of N160 million in its balance sheet.
Greenco can be compared with a public company Redco, which operates in the
same industry and has a similar business mix and business risk. The following
information is available about Redco:

Market value of equity N450 million

Equity beta 1.60
Debt capital Risk-free (debt capital=0)

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 Price to book value of equity 1.50 times
Gearing (total debt to equity value) 1.25

The rate of tax on profits is 30%. The risk-free rate of interest is 5% and the
equity risk premium is 3%.
Required
Use this information to estimate a cost of equity in Greenco.

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