Question

Question 4 On 31 December 2012, the total assets of Stream Berhad were RM10 million. The firm plans to invest in new projects costing RM5 million. Currently, the capital structure of the company, which is considered optimal, is as follows: Debt RM 3,500,000 Common stock RM 6,500,000 Total RM10,000,000 nhance the projects, the company plans to issue 9% irredeemable bonds at RM970 with a flotation of RM20 per bond. Common stock can be issued at its current market price of RM5 per share. on cost of 5% of market price will be incurred. The stockholders' required return is estimated to be consisting of a dividend yield of 6% and an expected growth rate of 9%. Next year's expected 15%, consisting dividend is RM0.20 per share. The company es paid on 1 million shares investment purp mpany earned a net profit after tax of RM3 million. However, dividends of RM0.28 per share will be on 1 million shares outstanding immediately. Only earnings after dividend would be available for stment purposes. The corporate tax rate is 25%. Scanned with CamScanner Financial Management for for Beginners 330 pany plans to use only Required: a. Determine the after-tax cost of the following: 1. New debt ii. Retained earnings iii. New common stock What would be the maximum size of the capital budget (in RM), if the company pla retained earnings for the equity portion? c. Calculate the firm's weighted average cost of capital if the above investments are under. d. Calculate the number of ordinary shares to be issued by Stream Berhad if the undertaken, assuming that the equity portion comes from a new issue of shares. ad if the projects are

Answer 1

4 (a) (i) Calculation of after tax cost of new debt

Cost of debt Kd = Annual interest payments / Net proceeds from issue of debt (1 - tax rate) (1-flotation cost)

= 9/95 (1-0.25) (1-0.20)

= 12.6 %

Here we have subtracted the flotation cost from Net proceeds to arrive at the post tax cost of new debt at 1.26%.

(ii) Calculation of after tax cost of retained earnings

Using Gordon growth model we have,

p0 = D1/Kre - g

Where,

p0 = current market price of share

D1 = Expected dividend

Kre = Cost of retained earnings

g = growth rate

Therefore putting the values we have,

5 = 0.2 / Kre - 0.09

Therefore Cost of retained earnings = 13%

where,

Current market price is RM 5

Expected Dividend is RM 0.2

Growth rate = 9%

(iii) The after tax cost of new common stock will be the stockholders required rate of return that is 15%.

(b) Maximum size of the capital budget (in RM) if the company plans to use only retained earnings

Particulars	Amount (in RM)
Net Profit after tax	30,00,000
Less: Dividend (0.28 x 10,00,000)	(2,80,000)
Earnings available for equity shareholders	27,20,000

Hence maximum size of the capital budget (in RM) if the company plans to use only retained earnings will be RM 27,20,000 or RM 2.72 millions.

(c) Calculation of firm's weighted average cost of capital if above investments are undertaken

WACC = (cost of equity x weight of equity) + (cost of retained earnings x weight of retained earnings) + (cost of debt x weight of debt)

= (0.15 x 6500000/15000000) + (0.13 x 5000000/15000000) + (0.126 x 3500000/15000000)

= (0.0650 + 0.0433 + 0.030)

= 0.1383 or 13.83 %

(d) The number of ordinary shares to be issued by Stream Berhad if the projects are undertaken assuming that the equity portion comes from a new issue of shares = Total amount to be raised / Current market price

= 5000000/5

= 10,00,000 shares