Question 4 (this question has three parts a), b) and c) (24 marks)

Part a.

1. While arranging capital for their business some managers follow the pecking order theory, can you explain what pecking order theory is and why managers choose such a theory to raise capital?
2. Calculate the rate of return available to shareholders for a company financing $1 million of assets with the following three arrangements:

1. All equity
2. 50% equity, and 50% debt at an interest rate of 12% per annum.
3. 25% equity, and 74% debt at an interest rate of 12% per annum.

The assets are expected to generate earnings before interest of $150,000 per annum in perpetuity.

(5+3=8 marks)

Part b.

What are the potential advantages and disadvantages to a companys shareholders if the company increases the proportion of debt in its capital structure?

(6 marks)

Part c.

1. From the below figures of Collingwood Public Limited, calculate Weighted Average Cost of Capital (WACC) and annual cashflows required by its capital providers.

Interest rate, kd	0.10
Statutory company tax rate, tc	0.30
Proportion of tc claimed by shareholders,	0.60
Market value of debt, D	$20 000 000
Cost of equity capital, ke	0.20
Market value of equity, E	$20 000 000

2. What are the main difficulties in calculating cost of capital for diversified companies?