Correlli Ltd, a taxation category 2 company, has done some preliminary evaluation of the following four investment

Question:

Correlli Ltd, a taxation category 2 company, has done some preliminary evaluation of the following four investment projects, as detailed below.

Investment ______________ Investment cost _______ Rate of return (%)

A................................$200,000 .....................18

B ............................... 125,000 .....................16

C ............................... 150,000 .....................12

D ............................... 275,000 .....................10

The latest balance sheet for the company shows:

Long-term debt .................................................................$

Bonds: Par $100, annual coupon 16.35%, 5 years to maturity ........... 1,500,000

Equity

Preference shares (55 000 shares outstanding, 94 cents dividend) ......550,000

Ordinary shares (825 000 shares issued) .................................... 1,650,000

Total .............................................................................. $3,700,000

The company's bank has advised that the interest rate on any new debt finance provided for the projects would be 8% p.a.

The company's preference shares currently sell for $9.09, and to induce investors to take up a new offering of preference shares the company would have to set the issue price at a discount of 4% off the present market price.

The company's existing shares sell for $3.03 each and management has disclosed that it expects to pay a dividend of 16 cents at the end of the next year. Historically, dividends have increased at an annual rate of 9% p.a. and are expected to continue to do so in the future. The ordinary equity component to finance new projects will require new shares to be sold at a 10% discount from the current $3.03 price, and the costs for undertaking the new issue are estimated to be 30 cents per share. The company tax rate is 30%.

(a) Determine the market value proportions of debt, preference shares and ordinary equity comprising the company's capital structure.

(b) Calculate the after-tax costs of finance for each source of finance.

(d) Determine which investments should be made.

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