Question Tag: Debt-to-Equity Ratio

Search 500 + past questions and counting.
Professional Bodies Filter
Program Filters
Subject Filters
More
Tags Filter
More
Check Box – Levels
Series Filter
More
Topics Filter
More
  • 8 Marks

AFM – May 2017 – L3 – Q2b – Sources of finance and cost of capital

Calculate the cost of capital for Oheneba Limited with two different capital structures.

Oheneba Limited is considering the acquisition of a concession in the Brong Ahafo region to enable it to start a quarry business. The average industry beta is 1.6 with an equity-to-debt ratio of 2:1.

The following information was extracted from the books of Oheneba Limited:

Income Statement

You are also informed that the long-term debt of the company is considered risk-free with a gross redemption yield of 10% and the beta coefficient of the company’s equity is 1.2, while the average return on the stock market is 15%.

Required:
i) Determine the cost of capital to apply for the appraisal of the quarry if Oheneba Limited will maintain its capital structure after the implementation of the quarry project. (5 marks)
ii) Determine the cost of capital to apply if the company will change its capital structure to 20% debt and 80% equity. (3 marks)

 

i) Cost of capital for the quarry if the company maintains its current capital structure:

The current capital structure of Oheneba Limited consists of GH¢100,000 in equity and GH¢35,000 in debt, so the debt-to-equity ratio is 0.35 (35/100).

We are given:

  • Industry beta: 1.6
  • Equity-to-debt ratio: 2:1
  • Tax rate: 30%
  • Long-term debt yield: 10% (risk-free)
  • Average return on the stock market: 15%
  • Company’s equity beta: 1.2

Ungearing the beta:
We first need to ungear the beta using the formula:

Next, we need to gear the beta for Oheneba Limited’s capital structure using the same formula:

ow, we can calculate the cost of equity (KeKe) using the Capital Asset Pricing Model (CAPM):

Ke=Rf+Be⋅(Rm−Rf)

Where:

  • Rf=10%Rf = (risk-free rate)
  • Rm=15%Rm = (market return)

Thus, the cost of capital for Oheneba Limited if it maintains its current capital structure is 14.7%.

ii) Cost of capital for the quarry if the company changes its capital structure to 20% debt and 80% equity:

We already know the asset beta (Ba=1.19Ba = 1.19).

Now we need to regear the beta for the new capital structure (20% debt and 80% equity):

 

  • 12 Marks

AFM – May 2019 – L3 – Q4b – Dividend policy in multinationals and capital structure decisions

Evaluate the financing options for Asana Ltd’s expansion, calculate the value of a right, dividend capacity, and debt-to-equity ratio under different methods.

Asana Ltd (Asana) is a manufacturing company based in Ghana. It is listed on Ghana’s stock exchange with a total market capitalization of GH¢400 million and 50 million shares outstanding. Its debt stock is made up of 10,000 18% bonds with a face value of GH¢100 each. Per the bond indenture, Asana is required to maintain a maximum debt-to-equity ratio of 80% and is prohibited from paying a dividend in any year unless its dividend capacity for that year is at least 45% of net income for that year. For the past three years, the company has not been able to pay dividends to its shareholders because it has not been able to meet the minimum dividend capacity requirement.

Presently, the company is planning an expansion project that could enhance its dividend capacity for the coming years. The expansion project is expected to increase profit before interest and tax by 15% above the recent figure of GH¢35 million. The directors are considering whether to use equity or debt finance to raise the GH¢50 million required by the expansion project. The amount required for the business expansion will be invested in additional property and equipment. Details of the two financing methods under consideration follow:

Method 1: Equity Finance
If equity finance is used, Asana will offer 1 new share for every 4 existing shares in a rights offer at a discount of 10% off the current market price.

Method 2: Debt Finance
If debt finance is used, Asana will raise the required GH¢50 million through a syndicated loan arrangement. The interest rate on this syndicated loan is expected to be 20%. It is assumed that the entire principal will be drawn immediately and paid back in a lump sum in 5 years’ time.

Additional information:

  1. Presently, the book value of equity is GH¢200 million, while the debt level is GH¢100 million.
  2. The recent profit before interest and tax is reported after charging depreciation of GH¢10 million and profit on disposal of non-current assets of GH¢2 million. The aggregate cost of the non-current assets sold is GH¢10 million, and their aggregate accumulated depreciation is GH¢8 million.
  3. In addition to the business expansion expenditure, GH¢2 million will be invested to maintain existing productive capacity in the coming year. This will be financed from retained earnings.
  4. Additional investment in net working capital will be 20% of the current net working capital balance of GH¢100 million.
  5. Asana pays corporate income tax at 22%.

Required:

i) Supposing equity finance is used, compute the value of a right.
(2 marks)

ii) Forecast the dividend capacity of Asana under both financing methods after the business expansion. Conclude whether Asana would be able to pay dividends to its shareholders in the coming year.
(5 marks)

iii) Compute the revised debt-to-equity ratio of Asana under both financing methods after the business expansion.
(3 marks)

iv) Use the results of the calculations above to evaluate whether equity or debt finance should be used for the planned business expansion.
(2 marks)

i) Value of a Right

ii) Dividend Capacity Forecast

Conclusion:
Asana would be able to meet its dividend capacity requirement if equity finance is used, as the dividend capacity (GH¢7.81 million) exceeds the minimum required. However, under debt financing, the dividend capacity (GH¢4.30 million) would not meet the required threshold, and the company would not be able to pay dividends.

iii) Debt-to-Equity Ratio

iv) Evaluation of Financing Methods

  • If equity finance is used, the company will have a lower debt-to-equity ratio (40%) and be able to pay dividends to shareholders, meeting both debt and dividend requirements.
  • If debt finance is used, the company will have a higher debt-to-equity ratio (75%) close to the maximum limit of 80%, leaving little room for future borrowing. Additionally, the company will not meet the minimum dividend capacity requirement.

Conclusion: Equity finance is the better option for the planned business expansion.

Take control of your business data with insight and in-depth understanding by taking this course. 

Services

Contact Info

  • +233203701923
    +233543919232
  • info@noohrabusiness.com

Get In Touch

Follow us on our social media and get daily updates.

Facebook-f Twitter Linkedin-in Envelope