Download Tutorial Week 5 Finance and more Exercises Finance in PDF only on Docsity!
AG215 Business Finance, Week 7 Tutorial
Tutorial sessions to cover questions 1, 4 and 7. Remaining materials for revision purposes and solutions provided online.
Question 1 Mixed Financing Plc has £25million in bank debt with an interest rate of 6.5%. It also has £20million of public bonds trading at par with an interest rate of 5.5%. Undated preferred stock is trading at an annual yield of 8%. The total preference dividend to be paid by the company next year is £2,400,000.
Mixed Financing Plc also has common stock that is publicly traded. The company forecasts a net dividend to its shareholders of £10,000,000 next year. Investors demand a required rate of return on common equity of 12% and the growth rate of earnings and dividend is 4%.
If the corporate tax rate is 30% what is the company’s weighted average cost of capital (WACC)?
PREFERRED = £2,400,000 / 0.08 = £30million
COMMON = £10,000,000 / (0.12 – 0.04) = £125million
Question 2 Multiple Financial Structure Inc has £6million of bank debt outstanding with an interest rate of 11% per annum. It also has perpetual corporate bonds paying total interest of £1million per annum. The yield offered by the corporate bonds is 8% per annum. Assume bank and public debt are trading at par value. In addition, the company has preferred stock worth £15million traded publicly, and offers a yield of 12%.
The company also has common equity outstanding. The company has just paid a total dividend of £3million. The growth rate of dividends is 5% and the required return on common equity is 15%.
If the corporate tax rate is 25% what is the company’s weighted average cost of capital (WACC)?
Corporate Bond Value = £1million / 0.08 = £12.5million
Common Equity Value = £3million * 1.05 / (0.15 – 0.05) = £31.5million
Question 3 Mogga Plc is seeking advice from its financial advisors on an appropriate weighted average cost of capital for the business.
Mogga has £10million in private debt outstanding with an interest rate of 8% per annum. It also has undated preferred stock trading with an annual yield of 12.5%. The total preference dividend paid by the company is £0.625million per annum.
Mogga Plc also has public debt outstanding, which is trading at par, with a market value of £25million and a yield to maturity of 6%. Finally, Mogga Plc publicly traded common stock. The company forecasts a dividend of £2.5million in total for the next financial year. The steady growth rate of earnings and dividends is 7% and investors demand a return of 17% on the company’s stock.
If the corporate tax rate is 40% what is the company’s weighted average cost of capital (WACC)?
PREFERRED = £625,000 / 0.125 = £5million
COMMON = £2,500,000 / (0.17 – 0.07) = £25million
Question 4
ßASSETS = ß (^) EQUITY[S/(S + B (1 - t))]
= 1.4 x 4/4.
= 1.1915 (where 4.7 = 4 + 1(0.7))
Step 2 – re-gear the asset beta to the leverage ratio of GG based on a debt-equity ratio of 1:2.5 or 2:5 used in the calculations below:
Regear the ß:
ß (^) EQUITY = 1.1915 x (5 + 2 (1 – 0.3))/
= 1.
R S = 3% + 1.525 (8% - 3%)
Question 5
Florence Plc has 200million shares outstanding at a price of 200pence per share. The company is seeking to expand its operations, and requires raising £100million of new capital for its new investments. The company has identified two funding opportunities; either to raise the funding via a public bond issue at an annual interest payment of 7 per cent, or alternatively to raise the finance through selling new shares at the current market price. Irrespective of the funding method chosen the company expects to generate expected earnings before interest and taxes (EBIT) £50million per annum in future years. The company pays tax on profits at a rate of 24 per cent.
a. Determine the EPS for the two financing possibilities following the implementation of the investment.
Ungeared Geared EBIT £50m £50m Interest - £7m EBT £50m £43m Tax -£12m -£10.32m EAT £38m £32.68m No of Shares 250m 200m EPS £0.1520 £0.
b. If the debt financing leads to a higher EPS is this a sufficient basis to decide to employ the debt rather than equity financing?
No! The EPS for a geared company will always be higher than that for an ungeared company as long as the rate of return on assets exceeds the interest rate. Using debt in the financing of companies introduces more risk and the EPS for a geared company is riskier than the EPS for an ungeared company. The difference in the risk implies the two EPS figures are not strictly comparable. Moreover, the decision on the form of financing should not be taken on the basis of the impact on EPS. If the objective of the company is to maximise shareholder wealth this should be the focus of attention and there s no simple link between the EPS and objective of value maximisation.
c. Earnings are uncertain and could fall below the expected level. At what level of earnings will the EPS turn out to be the same for the equity and debt financing plans?
Let the level of earnings at which the EPS for the ungeared and geared financing turn out to be the same be given by X in the following equation
Cost of capital for the ungeared financing is 17.5 per cent.
b. Determine a value for the company following the restructuring.
Assume Modigliani-Miller (1963) model with corporate taxes
VG = Vu + tcB (^) G
= £200m + 0.3 x £50m
= £200m + £15m
= £215m
VG = BG + S (^) G
£215m = £50m + SG
SG = £215m - £50m = £165m
Assumes that all the tax benefits of financing accrue to the equity holders.
c. Determine the cost of equity capital and the weighted average cost of capital following the introduction gearing.
R S =(X - RB B G ) (1 – TC )/S G
= (50 – 0.05 x 50) (1 – 0.3)/165 = 0.
R (^) S = R 0 + (R 0 – R (^) B) (1 – T (^) C) B (^) G /S (^) G
=0.175 + (0.175 – 0.05) (1 – 0.3) x 50/
= 0.
r (^) WACC = X (1 – TC )/V (^) G = 50(1 – 0.3)/215 = 0.
r (^) WACC = RS x SG /V (^) G + R (^) B (1 – TC ) x B (^) G/V (^) G
= 0.2015 x 165/215 + 0.05 (1 – 0.30) x 50/
= 0.
Question 7
Amos plc has always limited its borrowing to an overdraft to cover any unanticipated short term funding requirements. Its management is considering borrowing on a long term basis for the first time to finance a major investment programme. It has been established that it is possible to borrow £200 million at an interest rate of 7 per cent to cover the cost of the proposed capital expenditure. Alternatively it could issue 100 million shares at the prevailing market price of £2.00 through a private placement. The market has been kept informed of the company’s investment plans and it is anticipated that such an issue will leave the share price unchanged. The company currently has 240 million shares outstanding. The company's expected earnings before interest and taxes for next year, after taking the expansion of the company's assets into account, has been estimated to be £150 million. Assuming a corporate tax rate of 30 per cent determine:
a. The expected earnings per share of the company under both forms of financing.
EBIT
Interest
PBT
Tax
PAT
No. shares
EPS
Ungeared
150
0
150
45
105
340
Geared
150
136
-40.
240
b. The level of earnings before interest and taxes at which both financing plans will produce the same expected earnings per share.
Let the level of earnings at which the EPS for the ungeared and geared financing turn out to be the same be given by X in the following equation
EPS (U) = X(1 – t (^) c)/N(U) = (X – kiB (^) G )/N(G) (1 – t (^) c )
Eliminate common tax factors
X/N(U) = (X – ki B (^) G)/N(G)
Multiply both sides by N(U) and N(G)
The firm currently has market value of equity of £480m so raising £200m of equity would increase its value to £680m before inclusion of any tax benefits to debt.
e. Determine the company’s cost of equity capital and the weighted average cost of capital if the company employs the debt financing.
ke =(X - ki B (^) G ) (1 – tc )/S (^) G
= (150 – 0.07 x 200) (1 – 0.3)/540 = 0.
ke = ku + (k (^) u – ki) (1 – t (^) c) B (^) G /S (^) G
=0.1544 + (0.1544 – 0.07) (1 – 0.3) x 200/
= 0.
WACC = X (1 – tc )/V (^) G = 150(1 – 0.3)/740 = 0.
WACC = ke x S (^) G/V (^) G + k (^) i (1 – tc ) x B (^) G /V (^) G
= 0.1763 x 540/740 + 0.07 (1 – 0.30) x 200/
= 0.
