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Introduction

Solutions

1. a) Cost of equity

The cost of equity will be the expected return determined using the Capital Asset Pricing Model.  It will be calculated as follows:

 Expected Return (Jerome shares) = Risk free rate + Beta (Market return – Risk Free rate) (DePambphilis 2009).

 = 3.4 + 3.8 (8.5 – 3.4)

 = 22.78%

 b)  Cost of debt

 i) Borrowed from Consortium of banks

 The cost of the amount borrowed on from consortium of banks will be the interest rate which is 6.4%.

 ii) Borrowed through Bond issue

The cost of money borrowed from the fixed interest bond will be the yield to maturity of   the bond which is equivalent to the fixed annual rate of 3.4%.    

 c) After-Tax weighted average cost of capital

2. Net present value of the project on a five year cash flow basis

3. a) Internal Rate of Return

The internal rate of return is the rate that will result to a net present value of zero (Hunt 2009). 

8.25% give a net present value of 28,058.89696 Million.  20% gives a net present value of 14,739.7886.  Through extrapolation, the internal rate is 30.625%

  b) Payback Period

The payback period is the period that is taken to recover the initial investment in a project (Madura 2008).

The initial outlay will be recovered between year 3 and 4, precisely in 3 years and 5 months.

4.  Net cash flows that accrue to Jerome Shareholder and the shareholders expected return

The net cash flow accruing to Jerome Shareholders will be the total cash inflow less the repayment of loan and bond together with interest (Rastogi 2010).

  = Total cash inflow – loan and bond repayment – interest on loan and bond

   = 38825.11154 – (1.064^5) * 4,339.71 + (1.034^5)* 4426.50

   = 27, 675.25

The shareholder expected return is the cash flows accruing to the shareholders divided by the total cash outflow.

   = 27, 675.25/10,767.75258

   = 257.02%

5.  The risks facing investment companies who rely on high levels of leverage to increase shareholder returns. 

Use of high debt increases the shareholder value because it is cheaper than equity finance due to tax advantage.  However, use of high levels of leverage is risky to a business enterprise.  One risk is that collateral is needed in case of borrowing and when the business is unable to pay the debt, it may lose its assets.  High debt might pose cash flow problems to a business because of the interest payments and also reduce the business flexibility (Megginson & Smart 2008).  Most of the major decisions the business could make must involve the debtors and the consultation might take long hence less flexibility.  High debt also increases the bankruptcy risk of a business.  Thus a good balance must be made in order to maximize shareholder wealth and at the same time keep the business risk low (Benninga & Czaczkes 2000).  

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