Question

Logam Ltd. is a manufacturing company in Kenya with operations in four counties. Over the last six months, the company is engaged in a discussion on the choice of an appropriate mix of debt and equity. The company is considering the following levels of debt-equity ratios. The pre-tax cost of debt and beta values for cach debt-equity ratio is provided. Debt-equity ratios 20% 30% Pre-tax cost of debt 10% 12% Beta | 1.2 14 The effective tax rate for the company is 20% Furthermore, the following data for the most recent period has also been provided:- 2018 (Sh millions) 100 50 Investment in fixed capital Depreciation and Amortization Earnings before interest and tax Investment in Working Capital Cash and Cash equivalents 200 60 Logam Ltd. expects the free cash flow to the company to grow at an annual rate of 1070 for five years and 3% each year thereafter forever. However, it is also expo that investment in fixed capital and non-cash charges will offset each other during the stable growth period. Furthermore, the average return on the market and risk free rate of return has been estimated at 10% and 6% respectively Required: (a) For each level of debt-equity ratio, compute the cost of equity and after tax cost of debt (8mks) (1) Compute the weighted average cost of capital for the company given the debt- equity ratio levels. (Smks) (C) Estimate the free cash flow to the company for the most recent period (3mks) (d) Estimate the free cash flow to the firm at the end of the current period (3mks) (e) Estimate the horizon value of Logam Ltd. (6mks) (1) Estimate the value of operations for the company (10mks) (g) Estimate the enterprise value (3mks) (h) Based on your computations on (t) and (B) what would be the appropriate mix of debt and equity for Logam Ltd. (3mks)

Answer 1

Part a

Debt-equity ratio	Post tax cost of debt	Cost of equity
20%	8.00%	10.80%
30%	9.60%	11.60%

Part b

For D/E =20%
Source	Weightage (A)	Post tax cost of capital (B)	(A) x (B)
Debt	16.67%	8.00%	16.67%*8% = 1.33%
Equity	83.33%	10.80%	83.33%*10.80% = 9.00%
WACC = 1.33% + 9.00%
WACC = 10.33%
D/E = 0.2
If Equity = 1
Debt = 1*0.2
Debt = 0.2
Debt to Total capital = 0.2/(0.2+1)
Debt to Total capital = 16.67%
Equity to Total capital = (1 - Debt to Total capital)
Equity to Total capital = (1 - 16.67%)
Equity to Total capital = 83.33%
Cost of equity = Risk free rate + Beta*Equity risk premium
Cost of equity = 6%+(1.2*(10%-6%))
Cost of equity = 10.80%
Post tax cost of debt = Pre-tax cost of debt * (1 - tax rate)
Post tax cost of debt = 10%*(1-20%)
Post tax cost of debt = 8%
For D/E =30%
Source	Weightage (A)	Post tax cost of capital (B)	(A) x (B)
Debt	23.08%	9.60%	23.08%*9.60 = 2.22%
Equity	76.92%	11.60%	76.92%*11.60% = 8.92%
WACC = 2.22% + 8.92%
WACC = 11.14%
D/E = 0.30
If Equity = 1
Debt = 1*0.30
Debt = 0.30
Debt to Total capital = 0.30/(0.3+1)
Debt to Total capital = 23.08%
Equity to Total capital = (1 - Debt to Total capital)
Equity to Total capital = (1 - 23.08%)
Equity to Total capital = 76.92%
Cost of equity = Risk free rate + Beta*Equity risk premium
Cost of equity = 6%+(1.4*(10%-6%))
Cost of equity = 11.60%
Post tax cost of debt = Pre-tax cost of debt * (1 - tax rate)
Post tax cost of debt = 12%*(1-20%)
Post tax cost of debt = 9.60%

Part C

FCF at Year 1 = 50 * (1+10%)

FCF at Year 1 = 55

Part D

FCF = NOPAT + D&A - Capital expenditure - Change in working capital

FCF = (200 *(1-20%)) + 50 - 100 - 60

FCF at Year 0 = 50

NOPAT = EBIT * (1 - tax rate)