Jusco Ltd will require $11 million in capital in order to be viable and produce $1...

 

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Jusco Ltd will require $11 million in capital in order to be viable and produce $1 million annual cash flows in perpetuity. The prospective directors suggest that the $11 million is to be raised as a combination of debt and equity. There are three Directors - IT, Sales & Marketing, and Finance. All three Directors are aware of the significance of the cost of capital in the context of the following $11 million funding that needs to be raised. There are two proposals to be considered and assume the tax rate is 30%. Proposal X: The IT Director has proposed the following manner in which the $11 million should be raised as a combination of debt and equity as follows: $2 million debt - the debt should be raised by borrowing from a bank at a fixed rate of 6% per annum. $9 million equity - will be raised from an issue of shares. Shares with a similar systematic risk are currently offering an expected return of 11%. Proposal Y: The Sales & Marketing Director has suggested that a higher level of gearing is required and has proposed the following: The $7 million capital should come from lenders, and the $4 million from equity. The debt holders would require 7% per annum, while equity holders would expect a return of 16% annually. Required: Compute the following: (i) The Weighted Average Cost of Capital (WACC) under Proposal X. а. (ii) The WACC under Proposal Y. b. Critically discuss the benefits and limitations of using the Weighted Average Cost of Capital for investment appraisal. Jusco Ltd will require $11 million in capital in order to be viable and produce $1 million annual cash flows in perpetuity. The prospective directors suggest that the $11 million is to be raised as a combination of debt and equity. There are three Directors - IT, Sales & Marketing, and Finance. All three Directors are aware of the significance of the cost of capital in the context of the following $11 million funding that needs to be raised. There are two proposals to be considered and assume the tax rate is 30%. Proposal X: The IT Director has proposed the following manner in which the $11 million should be raised as a combination of debt and equity as follows: $2 million debt - the debt should be raised by borrowing from a bank at a fixed rate of 6% per annum. $9 million equity - will be raised from an issue of shares. Shares with a similar systematic risk are currently offering an expected return of 11%. Proposal Y: The Sales & Marketing Director has suggested that a higher level of gearing is required and has proposed the following: The $7 million capital should come from lenders, and the $4 million from equity. The debt holders would require 7% per annum, while equity holders would expect a return of 16% annually. Required: Compute the following: (i) The Weighted Average Cost of Capital (WACC) under Proposal X. а. (ii) The WACC under Proposal Y. b. Critically discuss the benefits and limitations of using the Weighted Average Cost of Capital for investment appraisal.