Tempo limited is a subsidiary of a Turkish company which manufactures household utensils .The company which is unlevered is currently financed by four million ordinary shares of GHS10.00 each par value. The shares have a market value of GHS13.50 per share, No debt finance has been used by the company. At a recent emergency board meeting to discuss the way forward as a results of the negative impact of the COVID 19 pandemic on the performance of the company, the Group manager of the company who was present told the shareholders that the company is planning to undertake a massive project expansion next year and suggested that the proposed project will be financed entirely by fixed interest debt, He proposed that, the project be financed by GHS5, 000,000 irredeemable debentures to be issued at par. At a subsequent meeting with company’s Directors and management, the finance director indicated that it is only possible to obtain debt finance equal to the entire cost of the project as the subsidiary has previously been all equity financed and has therefore considerable unused borrowing capacity. According to his calculation after obtaining the debt capital for the project, Tempo will be at level of gearing which will be optimum to the company. Tempo’s management team are, in principle, in favour of the expansion but there is considerable opposition to the use of debt finance and it is suggested that the project be funded by an issue of shares at their full market price. A)If the company decides to finance the project with debt capital, what factors should it take into consideration before deciding on the source of the debt capital B)Discuss how the decision to finance the project with debt capital will affect the return to equity shareholder taking into consideration Modigliani and Miller (M&M) irrelevance Proposition 2 argument C)Discuss any weaknesses of both the traditional and the Modigliani and Miller theories of capital structures and discuss how useful they might be in the determination of the appropriate capital structure of Tempo limited.
Tempo limited is a subsidiary of a Turkish company which manufactures household utensils .The company which is unlevered is currently financed by four million ordinary shares of GHS10.00 each par value. The shares have a market value of GHS13.50 per share, No debt finance has been used by the company. At a recent emergency board meeting to discuss the way forward as a results of the negative impact of the COVID 19 pandemic on the performance of the company, the Group manager of the company who was present told the shareholders that the company is planning to undertake a massive project expansion next year and suggested that the proposed project will be financed entirely by fixed interest debt, He proposed that, the project be financed by GHS5, 000,000 irredeemable debentures to be issued at par. At a subsequent meeting with company’s Directors and management, the finance director indicated that it is only possible to obtain debt finance equal to the entire cost of the project as the subsidiary has previously been all equity financed and has therefore considerable unused borrowing capacity. According to his calculation after obtaining the debt capital for the project, Tempo will be at level of gearing which will be optimum to the company. Tempo’s management team are, in principle, in favour of the expansion but there is considerable opposition to the use of debt finance and it is suggested that the project be funded by an issue of shares at their full market price.
A)If the company decides to finance the project with debt capital, what factors should it take into consideration before deciding on the source of the debt capital
B)Discuss how the decision to finance the project with debt capital will affect the return to equity shareholder taking into consideration Modigliani and Miller (M&M) irrelevance Proposition 2 argument
C)Discuss any weaknesses of both the traditional and the Modigliani and Miller theories of capital structures and discuss how useful they might be in the determination of the appropriate capital structure of Tempo limited.
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