Question $5$

Apex Ltd will require $$18$ million in capital in order to be viable and produce $$3$ million annual cash

flows in perpetuity. The directors suggest that the $$15$ million is to be raised as a combination of debt

and equity.

There are three directors $-$ Information Technology $($IT$),$ Sales & Marketing, and Finance. All three

directors are aware of the significance of the cost of capital in the context of the following $$18$ million

funding that needs to be raised. There are two proposals to be considered and assume the tax rate is

$30\%.$

Proposal Gemma: The finance Director has proposed the following manner in which the $$18$ million

should be raised as a combination of debt and equity as follows:

$$6$ million debt $-$ the debt should be raised by borrowing from a bank at a fixed rate of $6\%$ per annum.

$$12$ million equity $-$ will be raised from an issue of shares. Shares with a similar systematic risk are

currently offering an expected return of $12\%.$

Proposal Delta: The IT Director has suggested that a higher level of gearing is required and has

proposed the following:

The $$12$ million capital should come from lenders, and the $$6$ million from equity. The debt holders

would require $5\%$ per annum, while equity holders would expect a return of $10\%$ annually.

Required:

a$)$ Compute the following:

$($i$)$ The Weighted Average Cost of Capital $($WACC$)$ under Proposal Gemma.

$(5$ marks$)$

$($ii$)$ The WACC under Proposal Delta.

$(5$ marks$)$

b$)$ Analyse the difference between Proposal Gemma and Delta.

$(2$ marks$)$

c$)$ Critically discuss the benefits and limitations of using the Weighted Average Cost of Capital

for investment appraisal.

$(13$ marks$)$