11. (a) Briefly explain the significance of the firm's cost of capital. What are the factors determining
Question:
11. (a) Briefly explain the significance of the firm's cost of capital. What
are the factors determining that cost of capital, and how can that
cost be estimated?
(b) Given that debt finance is generally cheaper than equity finance,
explain why the firm is unlikely to use solely debt finance to fund
expansion.
(c) A commodity broker is contemplating the acquisition of a new
computer-driven management information system (MIS). The
hardware for this would cost an initial 4 million, whilst software
and staff training would cost 1 million for each of the first two
years operation, and 200 000 per year thereafter. After six
years, the system would be due for replacement. However
scrapping the current (manual) system would save staff costs of
1.5 million each year.
To finance the new investment the broker would use a combination of debt and equity capital in the ratio 1:3. The broker can
borrow at an interest rate of 10%, whilst interest paid can be set
against the corporation tax liability (currently taxed at 30%).
The broker is a listed company with a current share price of
3.00, and current dividend of 15 pence. Over the period the
share price is expected to grow at an annual rate of 6%.
Use the above information to evaluate investment in the new
MIS, finding the net present value and internal rate of return on
that investment.
What other factors should the decision-maker take into account?