SF Tutorial Five Answers

8/13/2019 SF Tutorial Five Answers

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BF2244 Strategic Finance

Worksheet Five - Answers

1.

Quip Plc has 2 million shares in issue currently trading at 3.15. Its only debt is in the form ofa 3yr bond with a coupon rate of 9% (face value = 100). The yield to maturity on the bond is6% and the bonds have a book value of 4.5 million. Corporation tax is 30%. Assuming areturn on equity of 14% what is the WACC?

ANSWER:

Since this firm has no preference shares, then for this firm:

( ) ed c

r E D

E r T

E D

DWACC

+

+

+

= 1

We therefore just have to find each variable in the equation. We are told r d= 6%, T c = 30%, r e=14%

The two variables we do not have are E and D:

E = Market value of equity = Number of share x Share price = 2 million x 3.15 = 6.3 millionD = Market value of debt = Number of bonds x Bond Price

Since each individual bond has a book value of 100 and all bonds have a total book value of4.5million, we know there are 4,500,000/100 = 45,000 bonds

Finally as we know the coupon rate, yield to maturity and life of the bond we can price it as wewould price any other bond:

10806.1

109

06.1

906.19

PriceBond32

=++=

So D = 45,000 x 108 = 4.86 million. Thus

( ) %73.90973.014.03.686.4

3.606.03.01

3.686.4

86.4==

+

+

+

=WACC

2. Explain what is meant by the equation: V L = V U + DT c. When do you think this equationworks best?

ANSWER:

The equation reflects the added value created by the tax shield effect of debt.

VU = the value of the Unlevered Firm (or ungeared or unleveraged) i.e. one with no debt,and this will depend on the business operations of the firm.


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And so the beta of the company is:

1.11.1100 =++=a

The firm is now proposing to replace some of the equity with debt i.e. our new proportions would become:

Proportion of debt = 60%

Proportion of preference shares = 0%

Proportion of equity = 40%

We are also told the new debt holders would require a return of 10% and the debt beta is 0.4

a. Since we are in the perfect world of M&M we know changes in capital structure do notalter the firms weighted average cost of capital, i.e. in the M&M world WACC (andtherefore also a) is fixed.

Therefore even after the proposed changes in capital structure the firms WACC wouldremain at 20% and firms beta would remain at 1.1

b. Our WACC equation however must still hold, both before and after the proposedchanges. After the changes we know that r d = 10% and from above that WACC = 20%,thus we have:

( ) er ++= 4.001.0016.02.0

i.e. er += 4.006.02.0

so( )

%3535.04.0

06.02.0==

=

er

c. In the same way, our company beta equation must hold, both before and after the proposed changes. We know that d = 0.4, and from above we have a =1.1 so now we

have:

e ++= 4.004.06.01.1

i.e. e += 4.024.01.1

so( )

15.24.0

24.01.1=

=e

Thus the risk and the expected return on the equity have increased because of the presence of

the debt. This reflects the added Financial Risk the equity holders are exposed to.


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4. Riff Plc has a WACC of 16%. If the required rates of returns are 22% and 8% on equity anddebt respectively, and corporation tax is 40%, then what is Riffs gearing level?

ANSWER:

With no preference shares we know: ( ) ed c r E D E

r T E D

DWACC

++

+= 1

So we have

Given the company must be funded by either debt or equity we also know that 1=+

++ E D

E E D

D

So E D

D E D

E +

=+

1 , for simplicity if we call the gearing level =+ E D

D , then we have:

( ) 172.022.022.022.0048.022.01048.016.0 =+=+=

Rearranging gives 3488.0172.0

22.016.0=

= Thus the gearing level of the company is ~ 35%

Note, instead of rearranging the equation we could have simply plotted a graph of WACC forvarious values of and then read of which value of gave a WACC of 16%.

5. What do we mean by the term Financial Distress? Give four examples of indirect costs offinancial distress.

ANSWER:

A firm is said to be in financial distress when it is perceived to be having difficulties meeting itsfinancial obligations. That obligation maybe a coupon payment on its bonds, interest on a bank loan, a

payment to suppliers or even wages to its employees.

Examples of indirect costs include:

Lost customers unable to honour guarantees

Higher costs suppliers less likely to offer credit or bulk reductions

Good employees may start to leave, or new ones less likely to join

Remaining employees have low morale, and lower productivity

Difficult (more expensive) to raise new finance

Reduced investment, R&D spending

Managers begin to make poor decisions, e.g. they accept risky, negative NPV projects

( ) 22.008.04.0116.0 +

++

=

E D E

E D D


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6. Assume the current riskless rate is 5% and the market premium is 8%. Sphere Plc is 30% debt,30% preference shares and 40% equity. Its preference shares have a beta of 0.8 whilst theequity has a beta of 1.2. Ignoring tax, calculate the WACC if;

a. The debt is riskless b. The debt has a beta of 0.2

ANSWER:

a. If debt is riskless then beta = 0.

As usual we start with the WACC equation:

( ) e pd c r E P D E

r E P D

Pr T

E P D D

WACC ++

+++

+++

= 1

We are told there is no tax and that the proportions of debt, preference shares and equity are0.3, 0.3 and 0.4 respectively. Thus we have:

e pd r r r WACC ++= 4.03.03.0

We thus need to find the required rate of return for each source of capital.

We are also told the risk-free rate (r f ) is 5%, the market premium (r m-r f ) is 8%. We can thus use theCAPM to find the required returns:

For equity, e = 1.2, thus

%6.14146.008.02.105.0 ==+=+= f me f e r r r r

For preference shares p = 0.8, thus

%4.11114.008.08.005.0 ==+=+= f m p f p r r r r

For debt, since the debt is riskless, the beta of the debt will be zero, i.e. d = 0, thus

%505.008.0005.0 ==+=+=

f md f d r r r r

Substituting these into the WACC equation gives:

%76.101076.0146.04.0114.03.005.03.0 ==++=WACC

Note, we could have also used the CAPM to find the WACC. The WACC is just the return on thecompany as a whole, so we would just need to put the beta of the company into the CAPM equation

72.02.14.08.03.003.0 =++=++

+++

+++

= e pd a E P D E

E P DP

E P D D

Thus WACC = %76.101076.008.072.005.0 ==+=+= f ma f a r r r r


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b. If debt has a beta of 0.2 then

If the beta of debt is had been 0.2 and not 0, then:

%6.6066.008.02.005.0 ==+=+= f md f d r r r r

Thus: %24.111124.0146.04.0114.03.0066.03.0 ==++=WACC

Alternatively, the beta of the company would have been:

78.02.14.08.03.02.03.0 =++=++

+++

+++

= e pd a E P D E

E P DP

E P D D

And so using the CAPM, again we can show that:

WACC = %24.111124.008.078.005.0 ==+=+= f ma f a r r r r

7. What do we mean by the WACC? Why is it important for firms? How does finance theory sayWACC might vary with capital structure? If increasing levels of debt can increase both thecost of debt and the cost of equity, can the WACC still fall?

ANSWER:

The WACC represents the average return the firm has to achieve in order to satisfy all the

different investors. If it fails to make this return it risks losing some of its investors.

There are several theories of capital structure, each putting forward a different view of whatwill happen to the WACC as you increase the level of debt in the company:

Theory: MM No tax: WACC doesnt change at allTrade-off: There is an optimum level of debt to minimise WACCMM With tax: WACC always decreases with increased debt

It is possible for both the cost of debt and cost of equity to go up, yet for the overall WACC tostill fall. For simplicity consider the WACC with no preference shares, so:

( ) E D

E r T r

E D D

WACC ecd +

++

= 1

Suppose the firm is 75% equity, and equity holders expect 20%, and 25% debt, and the aftertax cost of debt is 8%.

Then %1717.020.075.008.025.0 ==+=WACC .

Increasing debt to 50% might increase cost of equity to 22%, and cost of debt to 10%, so now

%1616.022.05.01.05.0 ==+=WACC

i.e. the cost of both debt and equity has risen, but the WACC has fallen


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8. What is the pecking order theory of capital structure? If this theory is valid, what sort ofcompanies would you expect to see with high levels of gearing?

ANSWER:

The pecking order theory states that firms prefer to raise funds through internal finance, and ifexternal finance is required, that they prefer debt to equity issues. This preference or pecking order results from the fact that investors may interpret security issues equity issues in particular asa signal that managers think the firm is currently overvalued by the market; therefore, investors willreduce their valuation of the firm in response to news of a stock issue. It also reflects the costsassociated with raising each sort of finance. Keeping retained earnings is obviously the cheapest way.The administrative costs of issuing new bonds are then generally less than the equivalent costs ofissuing new shares.

Pecking order theory thus says there is no optimal capital structure; instead firms just use the easiestsource of capital available until it runs out, and then move on to the next easiest source. If the peckingorder theory is correct, we would expect firms with the highest debt ratios to be those with low profits.

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