QUESTION -2 15+ 15 30 marks) Alfa Ltd operates a quite successful chain of milk
ID: 2819834 • Letter: Q
Question
QUESTION -2 15+ 15 30 marks) Alfa Ltd operates a quite successful chain of milk products and tea houses across Asia, Alfa plans to expand its business in Australia. Therefore, Alfa needs some funds for this investment. The company balance sheet in Australian Dollars(AS) is as follows South East s & G Inc.'s cat Cash Accounts receivable Inventories Net fixed assets Total assets 1,500,000 2.400,000 1,100,000 Debentures ($100 4,500,000 Common Stocks 9,500,000 Total Debt and Equity 9,500,000 000,000 D 4 500 000 Nowadays the company's common equity is selling for a price equal to2 times its book value and the Alfa's uses 15 percent to evaluate investments. The current return for Alfa debentures is 3% above the government bond rate. Currently Alfa's debentures were trading at $9850 value. (Return on market portfolio is 14.5 percent and Commonwealth Government bond rate S 4.5 per cent and Alfa's beta is 1.5. The firm faces a tax rate of 30 per cent. a. Estimate the weighted average cost of capital and how acceptable is the investment b. Assume the following and determine what the firm's weighted at 15 per cent? (15 marks) average cost of capital is - Alfa's stock price rises such that it is sold at 3 times its book value and the uses 16.5 per cent to evaluate the investment. Is this rate acceptable? (Assume the cost of debt and tax rate do not change). (15 marks) Pase wW Tota b. CAPM . Rf + [Rm-Rf] ions?Explanation / Answer
As per CAPM, the expected return on stock = risk free rate + Beta * (market return - risk free rate)
Hence Expected Return = 4.5% + 1.5 * (14.5% - 4.5%) = 19.50% . This is the cost of equity for the firm.
Cost of debt : Current Yield = (4.5% + 3%) = 7.5% After tax cost = 7.5% * (1-30%) = 5.25%
Market value of debt = 5000000 * 96.5/100 = 4,825,000.00
Market value of equity = 2 * 4500000 = 9,000,000.00
Total Capital at market value = 9000000 + 4825000 = 13,825,000.00
Equity weight in Total Capital = 9000000/13825000 = 65.10%
Debt weight in Total Capital = 4825000/13825000 = 34.90%
WACC = 65.10% * 19.5% + 34.90 * 5.25% = 14.53%
The discount rate of 15% being used by the company is close enough but is not exact and may lead them to reject some investment opportunities which otherwise at 14.53% discount rate may have positive NPV.
Part 2. If the market value of equity increases to 3 time of book value, then the market value of equity would be (4500000*3) = 13,500,000.00
Total capital at market value = 18,325,000.00
Equity weight in Total Capital = 13500000/18325000 = 73.67%
Debt weight in Total Capital = 4825000/18325000 = 26.33%
WACC = 73.67% * 19.5% + 26.33 * 5.25% = 15.75%
The WACC increases to 15.75% but is significantly lower than the 16.5% being proposed to be used by the company hence is not acceptable.
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