Finance Assignment Sample
Q1:
Answer :To evaluate the financing options for Mistral Manufacturing Ltd., it is essential to consider the cost of capital, impact on capital structure, and implications for shareholder value. The analysis involves calculating the Weighted Average Cost of Capital (WACC) under each scenario, considering tax implications, financial risk, and market perception.
Step 1: Understanding the Options
Equity Financing
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Equity financing involves issuing shares to raise AUD 50 million. This increases the company’s equity base but dilutes ownership.
- Advantages: No obligation to repay, avoids fixed interest costs, increases financial flexibility.
- Disadvantages: Dilution of existing shareholder control, higher cost of equity compared to debt.
Corporate Bonds
- Bonds involve raising AUD 50 million through debt securities with a fixed coupon rate.
- Advantages: Interest payments are tax-deductible, fixed obligations provide predictability.
- Disadvantages: Increases financial leverage, repayment obligation at maturity.
Syndicated Loan
- A syndicated loan is arranged by a consortium of banks, often for large financing needs.
- Advantages: Customizable terms, flexibility in repayment schedule, lower issuance costs compared to bonds.
- Disadvantages: Floating interest rates may increase financial risk, restrictive covenants.
Step 2: Calculating the Cost of Capital
Assume the following parameters:
- Risk-free rate (Rf): 3%
- Market Risk Premium (MRP): 6%
- Company Beta (β): 1.2
- Corporate Tax Rate: 30%
- Cost of Debt (Kd): 5% for bonds, 6% for syndicated loans
- Cost of Equity (Ke): Ke = Rf + (β × MRP)
Equity Financing:
Ke = 3% + (1.2 × 6%) = 10.2%
Cost of capital = 10.2% (entirely equity-based)
Corporate Bonds:
After-tax Kd = 5% × (1 - 0.3) = 3.5%
WACC = (50% equity × 10.2%) + (50% debt × 3.5%) = 6.85%
Syndicated Loan:
After-tax Kd = 6% × (1 - 0.3) = 4.2%
WACC = (50% equity × 10.2%) + (50% debt × 4.2%) = 7.2%
Step 3: Impact on Capital Structure and Shareholder Value
Equity Financing:
- Dilutes ownership; new shares reduce earnings per share (EPS).
- Costlier due to higher Ke, leading to reduced net present value (NPV) of projects.
Corporate Bonds:
- Maintains ownership but increases leverage, raising financial risk.
- Tax-deductible interest payments reduce effective cost.
Syndicated Loan:
- Flexible terms but potential exposure to floating interest rates.
- Restrictive covenants may limit operational flexibility.
Step 4: Recommendation
Based on the analysis, issuing corporate bonds emerges as the most favorable option:
- Lower WACC: 6.85% compared to 7.2% for syndicated loans and 10.2% for equity financing.
- Preserves Ownership: Unlike equity financing, bonds avoid shareholder dilution.
- Tax Efficiency: Interest payments are tax-deductible, reducing the effective cost.
While the syndicated loan offers flexibility, its floating interest rates and covenants increase financial risk. Equity financing, though free of repayment obligations, is the most expensive option due to a high cost of equity and dilution effects.
Implications for Financial Strategy
- Short-Term: Bonds provide predictable cash flows, aiding in financial planning.
- Long-Term: By maintaining a balanced capital structure (50:50 debt-equity), Mistral Manufacturing Ltd. ensures financial stability while leveraging tax benefits.
- Risk Management: The company should consider hedging strategies to mitigate potential interest rate risks associated with bond issuance.
In conclusion, issuing corporate bonds aligns with Mistral Manufacturing Ltd.’s financial strategy by minimizing the cost of capital, preserving shareholder value, and supporting sustainable growth in international markets.