Chapter # 03
Cost of Finance
Question # 01: {Exam Standard Question}
Zimba plc is a listed all-equity financed company which makes parts for digital cameras. The company pays out all available
profits as dividends. Zimba plc has a share capital of 15 million ordinary shares. On 30 September 20X0 it expects to pay an
annual dividend of Rs. 0.20 per share. In the absence of any further investment the company expects the next three annual
dividend payments also to be Rs. 0.20p, but thereafter a 2% per annum growth rate is expected in perpetuity. The company’s
cost of equity is currently 15% per annum. The company is considering a new investment which would require an initial
outlay of Rs.5 million on 30 September 20X0.
If this investment were financed by a 1 for 3 rights issue it would enable the share dividend per share to be increased to Rs.
0.21p on 30 September 20X1 and all further dividends would be increased by 4% per annum.
New investment is, however riskier than the average of existing investments, as a result of which the company’s overall cost
of equity would increase to 16% per annum were the company to remain all-equity financed.
Required:
(a) Assuming the Zimba plc remains all-equity financed and using the dividend valuation model calculate expected ex-
dividend price per share at 30 September 20X0 if new investment does not take place.
(b) Assuming the Zimba plc remains all-equity financed and using the dividend valuation model calculate expected ex-
dividend price per share at 30 September 20X0 if new investment does take place.
(c) Compare the market values with and without the investment and determine whether the new investment should be
undertaken.
Question # 09: {Spring-24, Q # 07, 12 Marks}
Arctic Meridian Limited (AML) specializes in the establishment, maintenance and operation of a fiber optic cable system.
Following information has been extracted from the latest financial statements of AML:
Rs. in '000
10 million ordinary shares @ Rs. 10 each 100,000
11% bank loan 15,000
The risk-free rate of return is 9%, while the risk premium is 6%. The equity beta for AML’s share is 1.1. The market value of
AML’s share is Rs. 45 each and is expected to grow by 5% per annum.
Expansion Plan:
AML is all set to expand its business by acquiring a local fiber optic business for Rs. 240 million. For this venture AML’s
management is considering either of the following two financing proposals:
(i) Issue right shares at a premium of Rs. 10 per share. The equity beta would remain unchanged under this proposal.
(ii) Issue 13% convertible bonds at par value of Rs. 1,000 each. The bondholders would have a right to either convert
each bond into 15 ordinary shares or redeem it at par at the end of the third year. This proposal would result in an
increase in equity beta to 1.2. The tax rate applicable to AML is 30%.
Required:
Recommend the financing proposal that would result in a lower weighted average cost of capital (WACC).
