KQK Co wants to raise $20 million in order to expand its business and wishes to evaluate one possibility, which is an issue of 8% loan notes. Extracts from the financial statements of KQK Co are as follows.
It is expected that investing $20 million in the business will increase income by 5% over the first year. Approximately 40% of cost of sales and other expenses are fixed, the remainder of these costs are variable. Fixed costs will not be affected by the business expansion, while variable costs will increase in line with income.
KQK Co pays corporation tax at a rate of 30%. The company has a policy of paying out 40% of profit after tax as dividends to shareholders.
Current liabilities are expected to increase by 3% by the end of the first year following the business expansion.
Average values of other companies similar to KQK Co:
Required:
(a) Assess the impact of financing the business expansion by the loan note issue on financial position, financial risk and shareholder wealth after one year, using appropriate measures. (10 marks)
(b) Discuss the circumstances under which the current weighted average cost of capital of a company could be used in investment appraisal and indicate briefly how its limitations as a discount rate could be overcome. (5 marks)