a) i) Current K_e:

Using Zeco‟s own equity beta:

K_e = 4% + 2.3(10% – 4%) = 17.8%

Project specific K_e:

Need to use the proxy (DCP) to derive a suitable beta as Zeco Plc own beta is not suitable for the new venture due to different risk.

• Degear the equity beta of the proxy (i.e. DCP). This means converting the equity beta to asset. This removes the financial risk of DCP.

β_A= V_e / (V_e+ V_D(1 −T)) β_e + V_D(1 −T) / (V_e+ V_D(1 −T)) β_D

V_e = 100m x N2.60 = N260m

V_D = N110m x 0.96 = N105.60m

β_A = 260 x 1.25 / 260+105.60 (1−0.20) + 0^* = 0.94

(* In the absence of information, it is assumed that debt is risk-free with beta of zero).

In the above calculations, remember to use the values of equity and debt of the proxy.

• Next, regear the above asset beta, using Zeco‟s financial gearing. This is to incorporate the financial risk of Zeco.

β_e= β_A+ (β_A− β_D) V_D / V_e (1 −t)

(Remember to use the values of equity and debt of zeco).

V_e = N40m/N0.50 × N1.05 = N84m

β_e = 0.94 + 0.94 −0 × (182.50 / 84 ) 1 −0.2 = 2.57

K_e = 4% + 2.57 × (10% – 4%) = 19.42%

iii) Comment The project-specific cost of equity is higher than the current cost of equity, indicating that a higher return would be needed by shareholders to compensate for the higher risk of the new venture. Appraising the venture using the existing cost of equity, as advised by the commercial director, would therefore result in an over-statement of the venture‟s net present value, potentially leading to an incorrect decision being made.

b) Gearing problems

Increased earnings volatility High gearing increases the volatility of Zeco Plc earnings as the interest payable is unaffected by any change in the activity level. If Zeco Plc experiences a reduction in its activity level, the percentage reduction in earnings will be greater than the percentage reduction in activity level. This increased volatility in earnings represents the financial risk of the company.

Cost of equity finance Increased volatility of earnings will increase the cost of equity, making equity finance more expensive. The financial risk premium can be seen by comparing the asset beta of 0.94 (K_e = 9.64%) with the equity beta of 2.57 (K_e = 19.42%)

Debt capacity The gearing level will affect Zeco‟s ability to raise new debt finance and how much debt it can support (debt capacity). Given its high gearing level, Zeco Plc may find that it cannot raise any more debt finance.

Bankruptcy risk High gearing leads to a high interest obligation for Zeco Plc and an increased risk of being unable to pay all of its interest following an unexpected reduction in profits/cash flow. This could result in default by Zeco Plc on its interest payments and subsequent forced liquidation by its lenders.

Note: Only three problems were required.

c) Risk –return relationship The risk-return relationship explains why different sources of finance have different costs. An investor‟s required rate of return will be determined primarily by the level of risk the investment has. If an investment carries a high level of risk, the investor will require a high rate of return to compensate for that risk, investing in a low-risk investment will mean a lower level of return will be required.

A rational investor would not invest in a high-risk investment offering a low return as they could obtain the same return in a lower-risk investment. A low-risk investment offering high returns would not exist as it would be undervalued and the high demand for that investment would increase the price and therefore reduce the return.

Zeco Plc finance costs

The risk-return relationship will result in Zeco Plc shareholders and lenders having different required rates of return.

The equity holders have no guaranteed return as Zeco Plc is under no obligation to pay a dividend each year and capital growth is also not guaranteed (in fact, the share price has fallen). Also, if the company was liquidated, the equity holders would come last in the order of payment and possibly receive nothing.

By comparison, the lenders (loan note holders and the bank) face lower risk as their interest is a contractual obligation and must be paid. The fall in share price will not directly affect the lenders as they do not participate in any capital growth/decline. Zeco Plc lenders do face the risk of default in the event of Zeco Plc being unable to pay the interest, but both the loan notes and the bank loan are secured on Zeco Plc assets so the risk of any loss due to default is reduced, assuming the assets realise sufficient value to repay the debt.

The above effects can be seen in Zeco Plc finance costs with their cost of equity being higher than their cost of debt. For example, the current cost of equity is 17.8% which is higher than the cost of bank loan which is only 7%. The loan notes are also cheaper, costing 10% (N6.50/N65.00). The loan notes are more expensive than the bank loan as they are irredeemable and thus have no guaranteed repayment date, increasing the risk compared with the bank loan which is repayable in the future.