QUESTION ONE

a) Mayfair Limited intends to introduce a new product, T, into the market. This will require

an investment in machinery costing Sh 2,400,000. The machinery is estimated to have a

useful life of four years with a terminal value of Sh 600,000.

Additional information;

1. Capital allowances will be provided on the machinery at a rate of 12.5% per annum on

a reducing balance basis. At the end of the useful life of the machinery a balancing

charge or allowance will arise equal to the difference between the scrap proceeds and

the tax written down value.

2. Annual profits from the sale of product T will amount to Sh 960,000 before deducting

depreciation on machinery.

3. Corporation tax at a rate of 30% is payable one year after the end of the accounting

year in which the tax was charged.

4. An investment in working capital amounting to Sh 240,000 will be required on

commencement of the project. This amount will however be recovered on completion

of the project.

5. The start of the project coincides with the start of the company's financial year.

6.The cost of capital per annum

REQUIRED

Using the net present value approach ,advice on the suitability of the project

QUESTION THREE

Two firms, A Ltd., and B Ltd., operate in the same industry. The two firms are similar in all aspects except

for their capital structures. The following additional information is available:

1.

A Ltd., is financed using Sh.100 million worth of ordinary shares.

2.

B Ltd., is financed using Sh.50 million in ordinary shares and Sh.50 million in 7%

debentures.

3.

The annual earnings before interest and tax are Sh.10 million for both firms. These

earnings are expected to remain constant indefinitely.

4.

The cost of equity in A Ltd., is 10%.

5.

The corporate tax rate is 30%.

Required:

Using the Modigliani and Miller (MM) model, determine the following:

(i)

The market value of A Ltd., and B Ltd.(ii)

The weighted average cost of capital of A Ltd., and B Ltd.