Which if any of the available investments would you recommend that the company accept? Explain your answer
Dude surfwear company is a growing manufacturer of casual clothing. During 2003 the London based company experienced sharp increases in both sales and earnings. Because of this recent growth, Melissa addup, the company’s financial manager, wants to make sure that available funds are being utilised to their fullest. Management policy is to maintain the current capital structure proportions of 30% Long term debt, 10% Preference shares and 60% Ordinary shares. The company’s tax rate is 40%.
Dude’s division and product managers have presented several competing investment opportunities to Ms. Addup. However because funds are limited, choices of which projects to accept must be made. The possible investment opportunities are shown in the table below :
Investment Opportunity Internal Rate of Return
IRR Initial Investment
A 15% £400,000
B 22% £200,000
C 25% £700,000
D 23% £400,000
E 17% £500,000
F 19% £600,000
G 14% £500,000
To estimate the company’s WAAC, Ms. Addup contacted a leading investment banking company, which provided the financing cost data shown in the following table ;
As a finance team you are required to calculate the following:
(a) The specific cost of each source of finance as specified
– long term debt at £450,000
– long tem debt greater than £450,000
– Preference shares
– Ordinary shares at £1,500,000
– Ordinary shares greater than £1,500,000
(b) Find the breaking point associated with each of the long term debt and ordinary shares funds ? (i.e. at what level of earnings available to ordinary shareholders will the cost of equity change). (formula is Amount of funds available from the finance source / capital structure proportion for that source)
(c) What is the WAAC over each of the ranges of total new financing specified in (b)?.
(d) Using your findings in (c) along with the investment opportunity table, draw the company’s weighted average cost of capital (x axis) against the IRR (y axis) of each investment.
(e) Which if any of the available investments would you recommend that the company accept? Explain your answer