QUESTION EIGHT A firm has Sh. 4 million of 7.5 % interest rate debt. Its expected EBIT is Sh. 0.9 million and WACC is 10 %. Using the Net Operating Income approach; (i) Calculate the value of the firm (ii) Calculate the cost of capital for the firm
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
QUESTION EIGHT
A firm has Sh. 4 million of 7.5 % interest rate debt. Its expected EBIT is Sh. 0.9 million and
WACC is 10 %. Using the Net Operating Income approach;
(i) Calculate the value of the firm
(ii) Calculate the cost of capital for the firm
QUESTION NINE
Consider two firms L and U which are identical in all aspects except for capital structure. The
EBIT and cost of capital for each firm is Sh. 900,000 and 10% respectively. U is an all-equity
financed firm while L has 7.5% of Sh.4, 000,000 debt.
a. Estimate the value of levered firm (L) and Unlevered firm (U) using Net Income (NI)
approach;
b. Establish whether there is an arbitrage opportunity
c. Estimate the arbitrage profits if any by considering an investor who holds 10% of the stock of
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