AUGUST-DECEMBER 2019

Assignment 2

FACULTY OF COMMERCE AND LAW

NAME OF STUDENT……………………………….. PISE MUNYARADZI

PROGRAMME ……………………………………. BACHELOR OF COMMERCE IN ACCOUNTING

HONOURS (BACH)

COURSE CODE………………………………………. BBFH202

COURSE NAME………………………………………. BUSINESS FINANCE 1

DUE DATE……………………………………………… 19 OCTOBER 2019

STUDENT PIN NUMBER…………………………. P1855138D

INTAKE………………………………………………….. THIRTY TWO

REGION…………………………………………………. MATEBELELAND SOUTH

PHONE NUMBER ………………………………….. 0772967536

Question 1(a)
Star computer system Limited has forecasted returns on its share with the
following probability distributions.

Calculate the expected return, variance and standard deviation of returns for Star.

Pᵢ Xᵢ PᵢXᵢ
-20 0.05 -1
-10 0.05 -0.5
-5 0.10 -0.5
5 0.10 0.5
10 0.15 1.5
18 0.25 4.5
20 0.25 5
30 0.05 1.5
Total 11%

The expected return = ∑(𝑝ᵢ 𝑥𝑖 )

=11

Pᵢ E(x) Xᵢ -E(x) (Xᵢ - Ex)² Pᵢ Pᵢ(Xᵢ - E(x))²

-20 11 -31 961 0.05 48
-10 11 -21 441 0.05 22.05
-5 11 -16 256 0.10 25.6
5 11 -6 36 0.10 3.6
10 11 -1 1 0.15 0.15
18 11 7 49 0.25 12.25
20 11 9 81 0.25 20.25
30 11 19 361 0.05 18.05
TOTAL 149.95

Variance = Σpᵢ(xᵢ -e(x))²

Variance = 149.95
8
= 18.74

Standard Deviation = The square root of variance

 = √18.74

= 4.329

1(b)

Calculate the portfolio return

State of the Probability Return (1%)

Economy
X Y
A 0.10 -8 0.4
B 0.20 2 -0.8
C 0.40 3.2 2.4
D 0.20 1 3
E 0.1 -0.4 4
EXPECTED 5 9
RETURNS

Portfolio returns = 0.5(5) + 0.5(9)

= 2.5 + 4.5

= 7
2(a)(İ)

Compute a weighted average cost of capital based on the existing capital

structure (8)

WACC = WdKd+ WpsKps + WeKe

Ke = 2 + 0.07
20

Ke= 17%

WACC = 3000 X 14%x0.5 + 1000 X 10% + 4000 X 0.10

8000 8000 8000

WACC = 0.15

WACC = 15%

2a(İİ)
Compute marginal weighted cost of capital (MWACC) if the company raises an
additional $2,000,000 debt by way of issuing debentures.(7)

=5000x0.14 (1 - 0.5) + 4000 x 0.17 + 1000 x 0.1

10000 10000 10000

= 11,3%

2a(İİİ)
Compute the cost of capital in (İİ) above if growth rate is expected to increase to
10% (5)

Ke= 2 x 0.10
20

= 20%

MWACC = 5000 X 0.14 X 0.5 + 0.20 X400 +1000 X 0.1

10000 1000 10000

= 12.5%

2a(İV) Explain why there is a cost associated with retained earnings. (5)
The cost of retained earnings is the cost to a corporation of funds that it has generated
internally. If the funds were not retained internally, they would be paid out to investors in
the form of dividends. Therefore, the cost of retained earnings approximates the return
that investors expect to earn on their equity investment in the company, which can be
derived using the capital asset pricing model (CAPM). The CAPM combines the risk-
free rate and a stock’s beta to arrive at the cost of equity capital.

Equity finance may be obtained in two ways. Firstly by utilizing Retained Earnings and
secondly by issue of additional equity. The cost of equity or the return required by equity
shareholders is the same in both cases. Irrespective of whether a firm raises equity
finance either by retained earnings or additional equity, the cost of equity is the same.
The only difference is in floatation costs. There are no floatation costs for retained
earnings whereas there is a floatation cost of 2 to 10% or sometimes even more for
additional external equity.

The companies do not generally distribute the entire profits earned by them by way of
dividend among their shareholders. Some profits are retained by them for future
expansion of the business. The cost of retained earnings is the earnings foregone by
the shareholders. In other words, the opportunity cost of retained earnings may be
taken as the cost of retained earnings. It is equal to the income that the shareholders
could have otherwise earned by placing these funds in alternative investments.

Retained earnings, as a source of finance for investment proposals differ from other
sources like debt, preference shares and equities. There are two alternatives or
opportunities to the retention of earnings . First, the amount retained would have been
distributed to the shareholders who in turn, would invest it and earn a return on it and
second, the firm itself could utilize them in external investment opportunities.

Accordingly, there could be two possible approaches to evaluate the cost of retained
earnings. The first of these criteria is based on what shareholders are able to obtain on
other investments, while second approach is expressed as "external yield criterion".