W5_Rotimi_Construction of New Head Office

1.    Problem Definition:

Financing of Head Office Construction:

my company intends to commence the construction of its new Head Office. From the Quantity Surveyors briefs, it is estimated that a total of $800,000 would be required for this project. How do we raise $800,000 for this project?

.

2.    Development of Feasible Alternatives

·         Raise the required capital internally through retained earnings and the issue of new shares

·         Obtain a commercial loan at a quoted annual rate of 15% from a commercial bank

·         Combination of retained earnings and commercial loan

3.    Development of Outcomes and cash flows for each alternative

To use shareholders funds for this project, we are to establish the return expected by my company's shareholders to compare with the interest rates being demanded by the financial institutions.

Using the Capital Asset Pricing Method (CAPM) to determine expected return by shareholders

Cost of equity = E(ri) = Rf + βi(E(rm) - Rf)

Where = Rf = Risk Free Return (Return on Government Treasury Bills) = 13.5%

                βi = Beta Value of Industry in which my company operates = 0.8%

            (E(rm) = Return on the Capital Market = 6%

Therefore, Cost of Equity = 13.5 + (0.06 * 0.8) = 13.5%

Facts

Cost of Equity (Return expected by shareholds = 13.5% per Annum

Interest rate charged by bank = 15% per Annum

4.    Analysis and comparison of alternatives

Using Internally generated revenue to finance the construction cost seems logical as it offers the cheapest funds at 13.5% compared with Bank A's offer at 15%. Financing with internally generated revenue will have a negative impact of the company's working capital. After a careful review of our options, Management has decided to fund the project using funds from both sources  as follows;

a.    Internally generated revenue  $300,000

b.    Loan from Bank  @ 15% $500,000   

Therefore, finding the weighted average cost of capital

            Weighted Average Cost of Capital (WACC)= גּ_e *i_{e  +} גּ_d *i_d (1 - t)

                Where  =גּ_e        Fraction of Total Capital Obtained from Equity

                        *i_{e  =}       Cost of Equity = 13.5%

                        גּ_{d =} = Fraction of Total Capital Obtained From Debt 

                            i_d = Cost of Debt

                           t =Effective Rate of Company Tax @ 24%

            WACC = (300,000/800,000) * 0.135  +  (500,000/800,000) * 0.15 * (1-0.24)

                        = 0.05625 + 0.07125

                        = 12.19%

5.    Selection criteria

a)         Effect on company's Working Capital

b)         Relatively Cheap Cost of Fund

6.    Selection of preferred alternative

The best alternative is to select a combination of both internally generated revenue and loan as the effective rate of interest will come down to 12.19%

7.    Performance Measurement and Post Evaluation Results

I will monitor the performance of this plan by comparing the actual total interest and returns made to the bank and shareholders respectively with the plan.

References

1.    Sullivan, W., Wicks, E., Koelling, P., Kumar, p., & Kumar, N. (2012). Engineering economy (15^th edition). England: Pearson Education Limited. The Capital Budgeting Process

2.    Head .A. (April 2008) Acca Student Accountant. The Capital Asset Pricing Model  Retrieved from http://www.accaglobal.com/content/dam/acca/global/PDF-students/2012/sa_apr08_head.pdf

3.    Trading Economics (2012) Nigeria National Statistics

 Retrieved from http://www.tradingeconomics.com/nigeria/indicators