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8/3/2019 Corrected Assignment FM
1/23
PART-A
(a)
Brown's debt ratio before afterthe capital restructuring
=
* 100
= 39.93%
Brown's debt ratio before afterthe capital restructuring
=
*100
= 42.35%
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(b)
Brown's WACC before capital structure
Cost of debt = (1-T) R * 100
=(1-.4) * .06 * 100
= 3.6%
Cost ofordinaryshare = 11%
Cost ofretained earning = ( .11 *
)
= 7.10%
Source of fund Book value Market value Proportionofeach element
Cost of eachelement
WACC
6% Debt 600000 600000 .39 .036 0.01404
Ordinaryshare 500000 850000 .56 .11 .0616
Retainedearning
75000 75000 .05 .071 .00355
1525000 1.00 .07919
7.9%WACC before re-structure
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Brown's WACC before capital structure
Source of fund Book value Market value Proportionofeach element
Cost of eachelement
WACC
6% Debt 600000 600000 .28 .036 0.01008
Ordinaryshare 500000 1450000 .68 .11 .0748
Retainedearning
75000 75000 .04 .071 .00284
2125000 1.00 .08772
8.78 %
(c)
I will use the cost of debt 3.6% as a discount rate because it is the lowest among all other discountrate including cost of equity,retained earning and WACC. Ifwe invest 700000 and re-structure our
capital,we can invest it byselling debenture as a rate of 6 %.
Kd = 3.6% < Ke= 11%, Kr= 7.10%, WACC = 8.78 %
WACC after re-structure
Re- investment of 700000
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PART-B
Step-1 : Calculation of net cash outlay
= 3905000 + 60000 6000
= 3959000
Total cost of the equipment :
Equipment cost 3500000
Software development ( 75000 * 3) 225000
Alterationof manufacturing line 180000
3905000
Cash inflow from old machine
Particulars 1styear 2
ndyear
Acquition cost 170000 305000
Accumulated dep. 100000 215000
Booksalvage value 70000 90000
Calculation of Net present value & Internal
rate of return
Total cost of the equipment + working capital tied up Cash inflow from old machine
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Cash salvage value 30000 140000
result Loss ( 40000) Profit ( 50000)
Difference 10000 ( profit)
After tax cash inflow from old machine = (1-.40) 10000
= 60000
Step-2 : calculation of annual depreciation
Depreciation =
=
= 547143
Step-3 : calculation of Net cash benefit
particulars 1st
year 2nd
year 3rd
year 4th
year 5th
year 6th
year 7th
year
Revenue 0 1200000 1200000 1200000 1200000 1200000 1200000
(-) operatingincome
Computeroperatorsalary
120400 120400 120400 120400 120400 120400 120400
Maintenancetechnical
125000 125000 125000 125000 125000 125000 125000
Gross Margin (245400) 954600 954600 954600 954600 954600 954600
(-)
administrativeexpenses
Training 35000 25000 10000
Depreciation 547143 547143 547143 547143 547143 547143 547143
EBIT (827543) 382457 954600 954600 954600 954600 954600
(-)interest 0 0 0 0 0 0 0
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EBT (827543) 382457 954600 954600 954600 954600 954600
(-) tax 40 % 152983 158943 162983 162983 162983 162983
NIAT (827543) 229474 238474 244474 244474 244474 244474
(+) non cashcharges
547143 547143 547143 547143 547143 547143 547143
NCB (280400) 776617 785617 791617 791617 791617 791617
Step-4: calculation of Excess cash flow from equipment & spare parts (7th year)
Excess cash flow from equipment
Booksalvage value 75000
Cash salvage value 0
(75000)
Tax savings = 75000 * .30 = 22500
Excess cash flow from equipment
Booksalvage value 60000
Cash salvage value 60000
Nil
Total = 60000 + 22500
= 82500
Net cash inflow for 7 years
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Period NCO
0 (3959000)
1 (280400)
2 776617
3 7856174 791617
5 791617
6 791617
7 791617
7 82500
Period NCB Present valuefactor6%
Present valueamount
0 (3959000) 1.00 (3959000)
1 (280400) .943 (264417)
2 776617 .890 691189
3 785617 .840 659918
4-7 791617 5.582 43350767 82500 .665 54863
1517629
NPV is positive thatswhy the equipment can be bought
Calculation of net present value
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IRR = UL
%
= 17 % -
%
= 17% - 0.034%
= 16. 97 %
IRR is more than the npv present value. thatswhy the equipment can be bought
Period NCB Present valuefactor17%
Present valueamount
0 (3959000) 1.00 (3959000)
1 (280400) .855 (239742)
2 776617 .731 567707
3 785617 .624 490225
4-7 791617 3.922 3104722
7 82500 .333 27473
(8615)
Calculation of IRR
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PART-C
Modigliani- Miller theorem
Definition :
A financial theorystating that the market value of a firm is determined by its earning powerand
the riskof itsunderlying assets, and is independent of the way it chooses to finance its investmentsor
distribute dividends. Remember, a firm can choose between three methodsof financing: issuingshares,
borrowing or spending profits (as opposed to dispersing them to shareholders in dividends). The
theorem gets much more complicated, but the basic idea is that,under certain assumptions, it makesno
difference whethera firm finances itselfwith debt orequity.
Theory, a form of modern thinking to capital structure :
y Traditional theory: if a firm substitutes debt forequity, it will reduce its cost of capital so increasingthe firms value:
r rD
D Er
E
D Er r r
D
D Ea d e e e d
!
!
.
y But, when the D/E ratio is considered too high, both equity-holders and debt-holders will startdemanding higher returns so that the cost of capital of the firm will rise. Hence, There exists an
optimal, cost minimizing value of theD/Eratio.
average cost of
capital
debt/equityratio
M-MM-M
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y Modigliani- Miller (M-M) proposition 1:The value of a firm is the same regardless of whether itfinances itself with debtor equity.The weighted average costof capital: ra is constant.
Assumptions of M-M: perfect and frictionless markets,no transaction costs,no default risk,no taxation,
both firms and investors can borrow at the same rd interest rate.
y Ex. Consider two firms: one has no debt while the other is leveraged (i.e. has debts). They areidentical in everyotherres pect. In particular they have the same level ofoperating profits: X. Let Ahave 1000 shares issued at 1 euro and B have issued 500 (1 euro) shares and 500 euroof debt.
Firm A Firm B
Equity E 1000 500
Debt D 0 500
y 100 sharesofB (1/5EB) give right toreceive a return:
R X r Dd
! 1
5
1
5
y 200 sharesofA (1/5EA) bought using 100 euroof borrowed money (100=1/5DB) give the same return:
R X r Dd
! 1
5
1
5.
y The two investmentsyield the same return (and have the same financial risk) Hence 1/5 ofA musthave the same value of 1/5 ofB: both sharesshould be equally priced. Ifnot, arbitrageurswill have
profitable operations at theirdisposal.
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Firm A Firm B
Possible
equilibrium
Firm A
Possible
equilibrium Firm
B
Operating profits X 10.000 10.000 10.000 10.000
Interests rdD 3.600 3.600
Profitsofshares X-rdD 10.000 6.400 10.000 6400
Shares market value E 66.667 40.000 68.000 38.000
Returnon equity re 15% 16% 14,7% 16,8%
Market value of debt D 30.000 30.000
Market value of firm V 66.667 70.000 68.000 68.000
Av. cost of capital ra 15% 14,3% 14,7% 14,7%
Debt ratio D/E 0% 75% 0% 78,9%
y FirmB isovervalued with respect toA. Anoperatorowning 1% ofB can:1.sellhissharesofB fora market value of 400;2. borrow 300 (i.e. 1% of the debt ofB) at rd= 12%3. buy 1% ofA fora value of 667.
y He then owns 1% of the unleveraged firm but has a debt equal to 1% of that ofB. His risk is
unchanged. Before he had an expected returnof 64 (=0.16400). Now he still have a returnof 64 (he
expects toreceive 100 = 0.15667 but he has to pay 36 as interests). But: before he had invested 400
of his money,nowonly 367=667300
y Hence it is profitable tosell B (the overvalued shares) and buyA (the undervalued ones). The price of
A rises and that ofB falls. The table shows a possible positionof equilibrium: ra is the same as it
should be since, by hypothesis,A and B have the same degree ofrisk. By contrast,re is higher for Bbecause itsglobal risk,which is equal to that ofA, has to be shared by a lowervalue of equity.
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y M-M proposition 2:the rate of return on equity grows linearly withthe debtratio.
From: rX
E Da
!
and rX r D
Ee
d!
it follows that: r E r E D r De a d! and hence that:
r r r r D
Ee a a d
!
y
M-M proposition 3:the distribution of dividends does not c
hange t
he firms market value: it onlychanges the mix ofEandD in the financingof the firm.
y M-M proposition 4:in orderto decide an investment, a firm should expecta rate of return at leastequalto ra,no matter where the finance would come from. This means that the marginal cost of capitalshould be equal to the average one. The constant ra is sometimes called the hurdle rate (the rate
required forcapital investment).
Example: Let ra = 10%. The return expected from an investment is 8% and it can be financed by
borrowing at 4%. The firm should not actuate this project. To see why, assume that the firm is
unleveraged, its expected operating profits are 1,000so that its market value is10,000 = 1,000/0.1. Theinvestment project is for100. If it is actuated, the firmsoperating profitswould be 1,008 and its market
value 10,080. But the firms equitywould be worth only9,980 because the value of the debt has to be
subtracted.
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Critique of the M-M theory by showing advantages &
disadvantages
y The M-M propositions are benchmarks,not end results: financing doesnot matterexcept formarket
imperfectionsorforcosts (f.e. taxes) not explicitly considered. A hint that financing can mattercomesfrom the continuous introduction of financial innovations. If the new financial products neverincreased the firms value, then there would be no incentive to innovate.
y Non-uniqueness of ra: perhaps it isnot very important.
y Taxation: since interests are considered as costs, a leveraged firm has a fiscal benefit. Itsoperatingearningsnet of taxes are:
X t X r D r D t X t r Dn c d d c c d! ! 1 1
while for anunleveraged firm they are: X t X
n c! !1
net profits. The difference:
t r Dc d
, once capitalized at ra, makes the value of the leveraged firm greater than that of the
unleveraged by the amount:
t r D
r
c d
a
. At the limit: the optimal capital structure might be all debt
(Miller). But it isnecessary to consider the personal taxationof capital gains, dividends and interests that
can (partially) offset the firms tax advantages. In the absence of offsetting,nothingwould sto p firms
from increasing debt in order to decrease taxation. There must be some costs to prevent aggressive
borrowing.
Footnote:
Fiscal shield: Drt dc
I have capitalized it at ar
According tootherscholars, ifyou assume that:
1. the firm expects togenerate profits2. the cash flows are considered to be perpetual
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>>the difference between the cash flowsof the leveraged firm and that of the unleveraged firm has the
same risk ofthe intereston debt.
>>hence you can capitalize the fiscal shield at dr so that:
DtVV cuL !
Instead of: Dr
rtVV
a
dcuL !
In any case:
But, is it correct to have anunlimited increase in LV ? It doesnot seem so.
Fiscal shield
D
VL
VU
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The present value of the distress costsreduce the present value of the fiscal shield.
y Risk of defaultor of financial distress: both the firm and the lenders may considernew debt toorisky.According to the trade-off theory, firmsseekdebt levels that balance the tax advantage of an increase
of debt with the prospective costsof possible financial distress. It so predicts moderate amount of debtasoptimal. But there is evidence that the most profitable firms in an industry tend to borrow the least,while theirprobabilityof entering in financial distressseems to be very low. This fact contradicts thetheory because, if the distressrisk is low, an increase of debt has a favourable (and almost riskless) taxeffect.
y Asymmetric information and agency problems. Financial policy acts as a signal forthe markets:1. A high leverage tends to improve the efficiencyof the managers. So investors tend to consider the
issue ofnew debt in a favourable way (up to a limit,of course).2. But, aswe shall see lateron, the managers may decide to actuate riskierprojects. To try to avoid this
outcome, the equity holders favours bankindebtment because they thinkthat the banks have powerfulmeans to control the managers. Bank can in fact threaten the managers with the request of debts
repayment.3. Managers could consider the issue of new shares. But they could also consider the risk of being
overthrown. Still more important is the risk coming from the possible market reactions. In fact, thewould-be stock investors tend to think that the managers, acting in the interest of existing
stockholders,would never issue newshares at anundervalued price. Theywould instead try tosell the
stockat anovervalued price. Hence the market would react in anunfavourable way, i.e. by marking-down the stockprice. The managers then prefernot to issue newshares even if this decisions has theeffect ofrejectingsome profitable investment programs.
4. Hence the form of finance the managers mostly prefer is undistributed profits. But they have toconsider that it is difficult to cut dividends inorder to have more internal finance. In all likelihood, themarket would react badly. In fact, an announcement of lower dividends is considered by investors as
VL
VU
D
Present value of distress costs
Fiscal shield
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an information that the firm isnot ingood health: the market value of the firm declines (the conversehappenswhen there is an announcement ofgreaterdividends).
5. The pecking order theoryrecognize that the internal resources and the external ones are not perfectsubstitutes in a world of asymmetric information between investors and managers. The formers askfora premium inorder to be compensated for the risk that the informationgiven them by managers isnotquite candid. The required premium is higher for the equity investors and lower for the debt investors.
The theory then maintains that the formsof finance preferred by managers have a definite order: 1.Undistributed profits; 2. Debt; 3. Equity. This fact has a relevant impact on the firms investmentdecisions: insufficient internal resources and difficulties in obtaining bank loans may result in thecurtailment of investments, in particularthose of the small and medium size firms.
6. Conflict s between debtholders and stockholders: only arise when there is a risk of default or offinancial distress. In the absence of this risk, debtholders have no interest in the firms value. But,when the riskissignificant, they have to considerall the costs that would reduce the value of the debt:
costsof lawyers and accountants,judiciary expenses, costsof the financial expertsof the court, and so
on;
lossofreputation and customers.
There are alsoAgency costs:when a firm has high debts, the shareholders have:
1.incentives to undertake riskier projects, evenwith the consequence ofreducing the expected value of
the firm. Example: Assume that the probabilityof both boom and depression is and
low risk high risk
Firms value Stock Debt Firms value Stock Debt
Depress. 400 0 400 200 0 200
Boom 800 400 400 960 560 400
Exp. Val 600 200 400 580 280 300
2.incentives to underinvest(debt overhang) as the foll. ex. shows.
Ex.: Considera firm with a debt of 2000 that will default in the case of depression. It has an investment
project that with an expenditure of 600 would forsure increase itsoperating profits by 900. The firms
expected profits X are shown in the following table, both with the investment actuated and without it:
State of the world X without I X with I
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Boom 2500 3400
Depression 1200 2100
Expected value 1850 2750
Note that: (E X I ! !900 600 300 . The value of the firmwould be increased by the investment. But:
State of without I without I with I with I
the world D E D E
Boom 2000 500 2000 1400
Depression 1200 0 2000 100
Exp. value 1600 250 2000 750
Note that: E E I( ! 500 600 so that the expected value of the equitywould be decreased by the considered investment.
y Hence, the existence of the conflict of interests means that the mere threatof default can influence afirms investment decisions in anunfavourable way. Since investorsunderstand thisrisk, the marketprice of both the debt and the stock decline. This is anothergood reason for managers tooperate atrelatively low debt ratios.
y Conflicts between managers and stockholders. The latterfavourdebt because, by forcing the managersto pay interest, force them to avoid inefficiencies, overinvestment and excessive utilization of thefirms resources to the managers benefit. The free cash flow theory that maintains that high debtratios increase firms value,notwithstanding the threat of financial distress, isuseful to explain thebehaviourof mature (cash-cow) firms that are prone tooverinvest.
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PART-D
(a) Cost of long-term debt, first $550 000 =
=
* 100 * (1-.40)
= 5.6 %
(b) Cost of long-term debt,greaterthan $550 000 =
* (1-t) * 100
=
*(1-.40) * 100
= 8.13 %
(c) Cost ofpreference share =
=
* 100
= 19 %
(d) Cost of ordinaryshare first 1.75 million =(
+ growth rate ) * 100
=(
+ G)
= (
+ .115)
= 19 %
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(e) Cost of ordinaryshare greaterthan 1.75 million =(
* 100
=(
+ .115) * 100
= 22 %
(f) Ranges of total new financing over which the firm's WACC remains constantbreak points associated with each source of capital and
To find where a break in the marginal cost of capital schedule occurs, we just need to know two
pieces of information: the weight of debt and the maximum amount of debts that can be sold at
5.6%. Here,
Weight of debt = 35 %
maximum amount of debts that can be sold at 5.6% = 550000
If 35% of the funds will be debt and the firm can raise up to 550000 at 5.6%, then how much
total funds from all sources can be raised without having to issue the more expensive 8.13 %debt? .35 of X has got to be less than or equal to $550000. So, if .35X
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(g) WACC over each of the ranges of total new financing of F
Name ofsources Amount weights Cost of capital WACC
Long term debt 280000 .35 0.056 0.0196
Preference share 120000 .15 .19 0.0285
Ordinaryshare 400000 .50 .22 0.11
0.1581
WACC = 16 %
(h)Graphical idea of the G firm's weighted marginal cost of capital (WMCC) and IOSWACC(B, C , D , F , G)
Name ofsources Amount weights Cost of capital WACC
Long term debt 280000 .35 0.056 0.0196
Preference share 120000 .15 .19 0.0285
Ordinaryshare 400000 .50 .22 0.110.1581
WACC = 16 %
WACC(A, E )
Name ofsources Amount weights Cost of capital WACC
Long term debt 280000 .35 0.056 0.0196
Preference share 120000 .15 .19 0.0285
Ordinaryshare 400000 .50 .19 0.095
0.1431
WACC = 14 %
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0%
5%
10%
15%
20%
25%
30%
A B C D E F G
IRR
WACC
X axis = Investment schedule opportunity
Y axis = IRR & WACC
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(i) Recommended investment :
Project IRR Initial Investment WACC
A 14% $300,000 14 %
B 25% $400,000 16 %
C 17% $600,000 16 %
D 14% $500,000 16 %
E 19% $300,000 14 %
F 16% $800,000 16 %
G 15% $400,000 16 %
Explanation :
Here,we should choose B. Because in proposal ofB IRR is highest than A,C, D, E, F, G. Also,
the WACC isonly 16 % which is also the minimum cost of capital. So, ifwe go for the proposal B,we
will be benefited byourhighest IRR 25 % & the cost of capital 16 %
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1. Advanced Corporate Finance
y Krishnamurti & Viswanath
2. Advanced Management Accounting
y Kaplan & Atkinson
3. Budgeting: Profit Planning and Controly Welsch, Hilton & Gordon
4. Principles of Corporate Finance
y Brealey, Richard A.; Myers, Stewart C
5. "The weighted average cost of capital, perfect capital markets and project life: a clarification"
y Miles, J.; Ezzell, J. (1980)
6. en.wikipedia.org/wiki/Financial_management
7. www.investopedia.com/terms/c/ costofcapital.asp
8. www.morevalue.com/i-reader/ftp/Ch13.PDF
Bibliography