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Capital structure consists of equity

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Ashraf Incorporated Ltd has assets with a market value of Rs.3 million. Its capital structure consists of equity, plus a loan of Rs.1, 000, 000 at an interest rate of 10 per cent per annum.

The company's cost of equity has been estimated at 23.5 per cent and its manager is considering a proposal to borrow a further Rs.500, 000 which would be used to buy back shares. The interest rate on the new loan is also 10 percent per annum.

a) Use MM's proposition 2 to calculate the effect of the increase in leverage on the cost of equity.

b) Calculate the company's weighted average cost of capital before and after the increase in leverage.

Instructions:

Use a 12-point font in Times New Roman.

Show all the necessary calculations because it carries considerable marks.

Reference no: EM131164771

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