A business needs ₦5,000,000 of financing. It can obtain a bank loan at 8% per annum interest, payable annually, with a corporate tax rate of 30% and a loan arrangement fee equal to 2% of the loan amount (paid upfront). Alternatively, it can raise equity by issuing shares at ₦200 each, expecting a dividend of ₦15 per share next year and a constant dividend growth rate of 5% per year. There are no flotation costs for equity.

Calculate the effective annual cost (as a percentage) of each source of finance and indicate which source is cheaper for the firm.

Question

A business needs ₦5,000,000 of financing. It can obtain a bank loan at 8% per annum interest, payable annually, with a corporate tax rate of 30% and a loan arrangement fee equal to 2% of the loan amount (paid upfront). Alternatively, it can raise equity by issuing shares at ₦200 each, expecting a dividend of ₦15 per share next year and a constant dividend growth rate of 5% per year. There are no flotation costs for equity.

Calculate the effective annual cost (as a percentage) of each source of finance and indicate which source is cheaper for the firm.

Accepted Answer

Loan effective cost = 7.76 %; Equity cost = 12.5 %; the loan is cheaper

Waec Model Questions Vol1 2023 Commerce Question 37

Answer Options

About This Question

Master the Exam!