Pompitus is a company which has recently been listed on the Belgium Stock Market. Its main business is developing new games for the android and is recently looking to develop a new game that allows players to shoot water bubbles at villains. This new game requires $40 million of new finance to be raised.

Until now, the finance manager uses a straight method of evaluating investments such as payback. Nevertheless, now that they are listed, the newly employed FM believes that they should be considering a more technical method of evaluating investment opportunities. He also believes that the capital structure should be considered as a tool for maximizing shareholder value rather than just a way of getting money as easily as possible. The finance manager, a fresh degree holder, remembers his professor of finance explaining about different theories of capital budgeting and believes his employer can benefit from the insights that arise from these theories.

The Pompitus Company is financed using the following ways:

1. Equity. The company has 20 million shares, which are trading at $16.00 per share. It has an equity beta of 1.2.
2. Preference shares. Pompitus has 20 million $1 10% preference shares, which are trading at $1.80.
3. Debt. Pompitus has $20 million of 20% bonds, which are redeemable at par in 10 years’ time. The bonds are currently trading at $210. The return on the market is 16% per cent and risk free government gilts are currently trading at 6%.

The corporate tax rate is 40 per cent. The new finance manager believes that adding substantial debt will be more beneficial than raising extra equity. However, the CEO believes that the least debt the better and cannot see any merit in adding to what he already believes is too much debt.

You being the secretary of Finance Manager explain your views with factual and numerical detail.

Answer rating: 100% (QA)

The Cost of each Source of Finance is Cost of Equity 18 Cost of Preference Shares 556 Cost of Debt 1... View the full answer