- 20 Marks
Question
a) The Directors of Moore Plastics Ltd have been deliberating on the company’s capital structure with a view to identifying an optimal financing mix. Opening the deliberation, the Board Chair remarked, “For the past 10 years, we have deployed a financing strategy of reinvesting as much profit as available. When profit is inadequate, we go for borrowing. New equity offers have been a last resort.”
Required:
i) Explain with THREE reasons why most managers tend to use financing strategies that follow the pecking order. (6 marks)
ii) Identify and explain TWO factors the directors of Moore Plastics Ltd should consider in redesigning the company’s capital structure. (4 marks)
b) Pusher Mining Ltd, a large listed company, operates five mineral concessions in Ghana and Ivory Coast. The company’s financial performance for the past five years has been impressive. The company’s recently published financial results indicate that it earned after-tax profit of GH¢250 million and paid dividends of GH¢50 million out of that profit.
Reserves at two of the five mineral concessions will be exhausted in two years’ time, and stakeholders fear this will adversely affect the company’s profitability. Nevertheless, the directors are aiming at maintaining the company’s dividend payment record. To achieve this, they want to pursue a new project in the oil industry to provide additional cash flows. Though the new project will be financed with existing equity and long-term debts, the directors are not sure what cost of capital to use in appraising the new project.
A summary of the company’s financial position before the new oil project follows:
| Item | GH¢m |
|---|---|
| Noncurrent assets | 620 |
| Current assets | 425 |
| Total assets | 1,045 |
| Equity | |
| Stated capital | 180 |
| Income surplus | 685 |
| Shareholders’ fund | 865 |
| Liabilities | |
| Current liabilities | 20 |
| Bank loans | 40 |
| Bonds | 120 |
| Total liabilities | 180 |
| Total equity and liabilities | 1,045 |
Notes:
- Stated capital: Pusher has in issue 40 million ordinary shares of no par value, all of which are listed on the stock exchange. The current market value of the ordinary stock is GH¢5.5 per share. It is estimated that the market value of the ordinary stock will increase by 8% per annum. The equity beta is 1.25.
- Bank loans: These are fixed-rate loans from banks in Ghana. The after-tax cost of the loans is 14.5%.
- Bonds: These are 16% coupon bonds with a face value of GH¢100 each. The bonds are currently trading at GH¢98.1 each. In 10 years’ time, the bonds may be either converted into 10 ordinary shares or redeemed at face value at the choice of bondholders. Bondholders are assumed to be rational investors.
If the new oil project is implemented, Pusher Mining Ltd’s main competitor in the oil industry would be Cargo Oil Ltd. The estimated equity beta of the competitor is 1.80 and the market value of its equity stock is GH¢150 million. The long-term debt stock of the competitor is valued at GH¢100 million. The systematic risk of debt stocks is assumed to be zero. The risk-free return is 14% and the market return is 20%. The corporate tax rate is 25%.
Required:
Estimate the appropriate cost of capital Pusher Mining Ltd should use in appraising the new project in the oil industry. Show all relevant computations. (10 marks)
Answer
a) Capital Structure Decision at Moore Plastics Ltd
i) Reasons for Following the Pecking Order
- Easier Access to Funds: Managers prefer sources of finance that are easier to access. Retained earnings, being the easiest to access and use, are the first choice. Borrowing comes next, as it is often easier to obtain compared to issuing new equity, which is typically the last resort due to its higher complexity and cost.
- Lower Issue Costs: Managers prefer financing sources with lower issue costs. Retained earnings have no issue costs, making them highly preferred. Debt usually has lower issuance costs compared to equity, thus it is favored over new equity offers.
- Signaling Effect: Managers believe that debt issuance sends a positive signal to the market about the company’s future prospects, indicating that management is confident about generating sufficient profits to cover the debt. Conversely, issuing new equity may be interpreted as a lack of confidence, leading to a decline in share price.
- Investors’ preference for safer securities: As debt stocks offer more secured
income streams to investors than equity stocks offer, it is easier for firms to
raise funds through debt offers than equity offers.
ii) Factors to Consider When Redesigning Capital Structure
- Business Risk: Business risk refers to the risk inherent in the company’s operations without considering debt. If Moore Plastics Ltd faces high business risk, the new capital structure should have a higher proportion of equity to reduce the risk of financial distress. If business risk is low, the company can afford to have a higher proportion of debt.
- Financial Risk: Financial risk is the additional risk to shareholders due to the use of debt. If the company already has high financial risk (i.e., high levels of debt), then the new capital structure should emphasize more equity to avoid excessive leverage. Conversely, if financial risk is low, the company might consider increasing its debt level.
- Tax position: The tax-benefit from the use of debt financing is high when the
company falls into a higher tax bracket. If the company is in a higher tax
bracket, a financing structure with more debt than equity would be
reasonable. - Clientele effect: An investor would prefer a particular capital structure to
another. So when redesigning capital structure, directors should consider
how present and prospective investors will react to the new capital structure.
b) Appropriate Cost of Capital for Pusher Mining Ltd’s New Oil Project
Calculation of WACC for the New Project
- Cost of Equity (Ke):
To calculate the cost of equity, we use the Capital Asset Pricing Model (CAPM).
- Equity Beta of Cargo Oil Ltd: 1.80
- Ungeared (Asset) Beta of Cargo Oil Ltd: 1.2
- Market value of Cargo Oil Ltd’s equity: GH¢150 million
- Market value of Cargo Oil Ltd’s debt: GH¢100 million
- Regear to reflect Pusher Mining Ltd’s capital structure:
- Cost of Debt (Kd):
- After-tax cost of bank loans: 14.5%
- After-tax cost of bonds:Bondholders will prefer to convert their bonds into shares because the conversion value (GHS118.7) is higher than the redemption value (GHS100).Cost of bonds (IRR)=12.6
- WACC Calculation:
- Market value of equity (Ve): GHS220 million (40 million shares × GHS5.5/share)
- Market value of debt (Vd): GHS157.72 million (GHS40m bank loans + GHS117.72m bonds)
Conclusion:
The appropriate cost of capital Pusher Mining Ltd should use to appraise the new oil project is 20.1%. This WACC reflects both the business risk associated with the oil industry and the financial risk of the company’s capital structure.
- Tags: Beta, Capital structure, Cost of Capital, WACC
- Level: Level 2
- Topic: Capital structure, Cost of capital
- Series: MAY 2016
- Uploader: Kwame Aikins