Question

put. (JUWS Question two (40%) . MTP Lid is a newly established firm in Tanzania which produces and sells Mango juice all over the country. The directors of the company are planning to expand the company capacity by opening another processing center in Arusha region. According to the market analysis as well as financial analysis, investing in Arusha is feasible as it will enable the company to capture more market within the country and outside the country. Currently, MTP Ltd has invested a total capital of 50,000,000 which is all financed by equity shares from owners of the company. finance manager has estimated that the company need 70,000,000 Shillings to establish the processing center and has provided the following financing options that can be considered if the decision to expand the firm's operations has to be implemented. Source of capital Required Retur/Interest Issue Equity shares 12% Issue Corporate bonds 5% Bank debts 8% According to the MTP Ltd board of director's decisions, the company debt to equity ratio should not exceed 50% in order to minimize bankruptcy risk and the company can issue corporate bonds to the tune of 10,000,0000 shillings only. The corporate tax rate is 20%. Required 2. Basing on the information above, what will be resulting feasible capital structure for the company (25 Marks) b. Calculate the resulting weighted average cost of capital basing on the capital structure in part (1) above (15 Marks)

Answer 1

a) It is given that existing equity capital is 50,000,000 Shillings and it requires 70,000,000 Shillings to establish a processing center. It means that total capital of the firm will be 120,000,000 Shillings. Also, it is given that firm's debt-to-equity ratio should not exceed 50%. Therefore, if equity is taken as 1.0, total capital of the firm should 1 + (1x50%) = 1.5. As a result, Target equity capital = 120,000,000 x (1/1.5) = Target debt capital = 120,000,000 x (0.5/1.5) = 80,000,000 Shillings 40,000,000 Shillings Out of 40000000 Shillings of target debt capital, company can issue Corp.Bonds maximum 10,000,000 So, balance 30,000,000 Shillings shall be raised through Bank Debts. Capital structure of the company and each capital's weight in company's total capital shall be as below: Value 80,000,000 Source Equity Corp. Bonds Bank Debts Weight 0.6667 0.0833 0.2500 [80000000 / 120000000] [10000000 / 120000000] (30000000 / 120000000] 30,000,000 120,000,000

b) After-tax cost of debt = Before-tax cost of debt x (1 - Tax rate) 5% Before-tax cost of debt Tax Rate After-tax Semiannual cost of debt Corp. Bonds Bank Debts 8% 20% 20% 4.0% 6.4% NOTE: Corp. Bonds = 5% x (1-20%) = 4.0%; Bank Debts = 8% x (1-20%) = 6.4%. Therefore, Capital Source Cost weight Equity 0.6667 12.0% Corp. Bonds 0.0833 4.0% Bank Debts 0.2500 6.4% Company's Weighted Avg. Cost (WACC) Weighted Cost 8.00% 0.33% 1.60% 9.93% (0.6667 x 12%] [0.0833 x 4%] (0.25 x 6.4%] [8% +0.33% + 1.6%]