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Question 1 (20 marks)

ABC Ltd, a firm with a fully integrated dividend imputation system, is contemplating taking on two projects. The first project would cost $2 million and the second project would cost $1 million. Given the information below, should ABC go ahead with the projects if their required rate of return for both projects is 11%, and the company tax rate is 30%?

- Bonds: New $100 10 year bonds would be issued with a 7% coupon rate, paid semi-annually. Currently similar bonds are selling for $106.59. New bonds would cost $2.34 per bond to issue. However, if bonds are issued in excess of $500,000, the expected selling price would be $96.94.

- Preference Shares: ABC currently have $1 par value, 6.5% preference shares, and believe they can issue more with the same conditions. The shares are currently selling for $0.95 and issue costs for new shares would 5% of market value.

- Equity: ABC has just paid an annual dividend of $0.45 per share. Dividends have been growing at 4% pa for the last two years, and this trend is expected to continue into the foreseeable future. If the firm wishes to finance the project with equity, there is $300,000 available in retained earnings. If they raise new equity, issue costs will be 7% of the selling price. ABC shares are currently selling at $6.70. If more than $400,000 of new equity is sold, the expected selling price would be $6.45.

- The optimal capital structure which the firm will use is:

Debt:	40%
Preference shares:	10%
Equity:	50%
	100%

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