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BFN1014 ASSIGNMENT 2 TRI 2 2012 2013

FINANCIAL MANAGEMENT 1
Assignment 2

Maman Food Industries has been revolutionizing its plastic container and trying to do its
part to save the environment. As the chief financial officer (CFO) of a young company
with lots of investment opportunities, Maman’s CFO closely monitors the firm cost of
capital. The CFO main duty is to consistently monitor and evaluate each of the individual
cost of capital: long term debt (25%), preferred stock (25%), and common stock (50%).
At the present time, Maman can raise debt by selling, 15 year bonds with a RM 1000 par
value and a 10% annual coupon interest rate. Maman’s corporate tax rate is 28% and its
bonds generally require an average discount of RM 40 per bond and floatation costs of
RM28 per bond when being sold. Maman’s outstanding preferred stock pays a 8%
dividend and has RM102 per share par value. The cost of issuing and selling additional
preferred stock is expected to be RM12 per share.

Currently Maman’s retained all the profits and practice “zero dividend” policy for the
first five years of its inception. To track the cost of common stock the CFO uses CAPM.
The CFO and the firm’s investment advisors believe that the appropriate risk free rate is
5% and that the market’s expected return equals 15%. Maman’s CFO estimates the firm’s
beta to be 1.8.

Although Maman’s current target capital structure includes 25% preferred stock, the
company believes that retiring the outstanding preferred stock will reduce its weighted
average cost of capital (WACC), thus shifting their target capital structure to 50% long
term debt and 50% common stock. If Maman shifts its capital mix from preferred stock to
debt, its financial advisor expects its beta to increase to 2.0.

Required:
a) Calculate Maman’s current after tax cost of long term debt.
b) Calculate Maman’s current cost of preferred stock
c) Calculate Maman’s current cost of common stock
d) Calculate Maman’s current weighted average cost of capital.
e) Assuming that the debt financing costs do not change.

i) What effect would a shift to a more highly leveraged capital structure consisting of
50% long term debt, 0 % preferred stock and 50% common stock have on the risk
premium for Maman’s common stock?

ii) What would be Maman’s new cost of common equity?

f) What would be Maman’s new weighted average cost of capital?

g) As a Chief Executive Officer (CEO), discuss which capital structure is more suitable
for your company if there are new projects coming up for your firm?

BFN1014 ASSIGNMENT 2 TRI 2 2012 2013
i) Referring to part (g) of the question, use the chosen weighted average cost of capital
(WACC) and calculate the Net Present Value for Maman Food Industries if the
government offers two mutually exclusive projects (A and B) to manufacture
environmentally friendly food container.

Year Project A Project B
1 230,000 120,000
2 210,000 210,000
3 180,000 100,000
4 235,000 89,0000
5 120,000 400,000

Note: The initial investment for this project is RM 1,000,000.

ii) Which projects are better? Discuss.

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