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JNB518 Finance For Decision Making

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  • Course Code: JNB518
  • University: University Of Tasmania
  • Country: Australia

Question:

Assignment Tasks:

Firm X is a new firm, and has the opportunity to invest in its first new project. The new project will require investment of $100,000, and is expected to provide net cash flow of $40,000 per annum for the foreseeable future (that is, it can be treated as a perpetuity). The board are discussing the best way to raise finance for the new project.

A heated discussion follows. One board member has just been on a course on Miller-Modigliani, and announces that “it does not matter how we finance the project. It will not affect the value of our company. What matters is that the project has a positive NPV at a discount rate of 15%. Therefore, we should take it with any financing mix.”

Another board member disagrees. He argues “The financing mix does matter! It is crucial that we find the right capital structure, especially as we pay corporation tax of 40%.”

Further Information:

The finance director has obtained two possible estimates of the pre-tax cost of capital for different capital structures as follows (for simplicity, assume that the pre tax and post tax cost of equity is identical);

Case 1: Risk Free Debt

% Debt/ % equity.

Cost of Debt (%)

Cost of Equity (%)

0/100

5

15

10/90

5

16.2

20/80

5

17.5

30/70

5

19.3

40/60

5

21.7

50/50

5

25

60/40

5

30

70/30

5

38.5

80/20

5

55


Case 2: Risky Debt

% Debt/ % equity.

Cost of Debt (%)

Cost of Equity (%)

0/100

5

15

10/90

5

16.2

20/80

5

17.5

30/70

5

19.3

40/60

5

21.7

50/50

5

25

60/40

6

30.5

70/30

7

39.4

80/20

8

57

Required:

  1. You are required to prepare a numerical analysis for the board regarding the effect of capital structure on firm X’s cost of capital and firm value. You should analyse 4 cases: a) risk-free debt without tax. b) Risky-debt without tax. c) Risk-free debt with tax. d) Risky debt with tax. In each case, you should present tables, and graphs, that show the WACC and project values for different debt-equity ratios. Your report should recommend the optimal capital structure for the new project in all cases.

  2. The CEO likes your report, but points out that it only tells half the story. In particular, he is concerned that it ignores the agency and signalling effects of capital structure. He requests a further brief report examining these problems, and how they might affect firm X’s financing decision and firm value.
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[Accessed 26 February 2021].

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My Assignment Help. Finance For Decision Making [Internet]. My Assignment Help. 2021 [cited 26 February 2021]. Available from: https://myassignmenthelp.com/free-samples/jnb518-finance-for-decision-making/firm-x-capital-structure-decision.html.


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