FM – Nov 2023 – L3 – SB – Q4 – Financial Risk Management

Assess whether debt or equity financing is more suitable for a business expansion and discuss related financial concepts.

Question

Xeco is considering a N15 million expansion to increase profit before interest and tax by 20%. Financial details for Xeco are as follows:

Financing Options:

Debt: Issue N15m in 8% loan notes, with each note at a nominal value of N100.
Equity: 1-for-4 rights issue at a 20% discount to current share price (N6.25/share). Xeco has 12 million shares outstanding.
Corporate tax rate: 30%.

Required:

a. Evaluate whether Xeco should finance the expansion with debt or equity. (10 Marks)
b. Explain the relationship between systematic and unsystematic risk. (5 Marks)
c. Discuss the assumptions made by the Capital Asset Pricing Model (CAPM). (5 Marks)

Answer

b. Systematic vs. Unsystematic Risk

Systematic Risk: The market-wide risk that affects all securities and cannot be diversified away (e.g., economic recession).
Unsystematic Risk: Firm-specific risk that can be mitigated through diversification (e.g., business decisions).

c. Assumptions of CAPM

CAPM assumes investors are rational and markets are efficient, that there’s a single-period horizon, and that risk is measured by beta. It also assumes that investors can borrow and lend at the risk-free rate.