1Chakngeny Diaries Ltd is considering investing in a new milk cooling system with the following characteristics:
A Initial Investment KES 7,360,000-no scrap value
B Expected Economic Life 5 years
C Sales Volume 1,120,000 litres per year
D Selling Price KES 15 per litre
E Variable Costs KES 11 per litre
F Fixed Costs including Depreciation KES 3,100,000 per year
The company’s opportunity cost of capital is 15% and it uses the straight line depreciation method. Its marginal tax rate is 40%.
a. Calculate the NPV (unadjusted for risk) of the project. (11 marks)
b. Recalculate the NPV assuming each of the characteristics, B, and D varies, in isolation, adversely by 10%. (12 marks)
c. Comment briefly on the vulnerability of the two variables in (b) above. (2 marks)
Question Three. (Total 25 marks)
a. Kianjoya Ltd has 2 million ordinary shares outstanding at the current market price of KES 60 per share. The company requires KES 8 million to finance a proposed expansion project. The board of directors has decided to issue a 2- for -25 rights at a subscription price of KES 1,660,000. Information on this project will be released to the market together with the announcement of the rights issue. The company paid a dividend of KES 6 per share last year. This dividend, together with the company’s earnings is expected to grow at 6% annually.
i. Compute the price of the shares after the announcement of the rights issue but before they start selling ex-rights. (9 marks)
ii. Compute the theoretical value of rights and the theoretical ex-rights price of the shares. (6 marks)
b. Identity and explain three methods of handling risks in capital budgeting. (10 marks)
2a. Big Bee Ltd has a cost of equity of 10%.Currently; it has 250,000 ordinary shares which are quoted at the stock Exchange at KES 120 per share. The company’s earnings per share are KES10 and it intends to maintain a dividend payout ratio of 50% at the end of the current financial year. The expected net operating income for the current year is KES 3 million and the available investment proposals are estimated to cost KES 6 million.
i. Using the Modigliani and Miller (MM) model, show that the payment of dividends does not affect the value of the firm. (8marks)
ii. What are the assumptions inherent in MM model? (2 marks)
b. Assuming all things are held constant other than the item in question, for each of the companies below:
i. A company with a large proportion of insider ownership, all of whom are highly income individuals.
ii. A growth company with an abundance of good investments opportunities.
iii. A company experiencing ordinary growth that has high liquidity and much unused borrowing capacity.
iv. A dividend paying company that experiences an unexpected drop in earnings from a trend.
v. A company with volatile earnings and high business risk.
Explain whether or not you would expect each company to have a medium/ high or low dividend payout ratio and the reasons for such categorization. (15 marks)
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