On capital structure and dividend policy

Question 1 Semai Maju is considering converting its all-equity capital structure to one that is 40% debt. Currently there are 2,000 shares outstanding and the price per share is RM20. Earnings before interest and tax (EBIT) is expected to remain at RM25,000 per year forever. The interest rate on new debt is 7% and there are no taxes. a) If you currently own 100 shares of Semai Maju, what is your cash flow under the current capital structure, assuming 100% dividend payout rate? (2 marks) b) How much debt must Semai Maju raise to achieve the new capital structure? Calculate also the annual interest payment for the new debt. (3 marks) c) If you keep 80 shares and sell back to the company 20 shares, what is your total cash flow for that year, assuming 100% dividend payout rate? (5 marks) A EPS = 25,000/2,000 = RM12.50 Total cash flow = 12.50 x 100 = RM1,250 B Market value of equity = 2,000 x RM20 = RM40,000 New debt = 0.4 x RM40,000 = RM16,000 Interest = 0.07 x RM16,000 = RM1,120 C shares repurchased = RM16,000/RM20 = 800 shares Net income p.a. = RM25,000 RM1,120 = RM23,880 EPS = RM23,880/(2000 800) = RM19.90 Cash flow from dividend = RM19.90 x 80 = RM1,592 Cash flow from selling 20 shares = RM20 x 20 = RM400 Total cash flow = RM1,592 + RM400 = RM1,992

QUESTION 2

The Aggie Company has EBIT of $50,000 and market value debt of $100,000 outstanding with a 9% coupon rate. The cost of equity for an all equity firm would be 14% and the cost of debt capital is 10%. Aggie has a 35% corporate tax rate. Investors face a 20% tax rate on debt receipts and a 15% rate on equity. Determine the value of Aggie and its WACC.

VL = VU + tcB Where, Vu = EBIT(1 tc)/R0 Unlevered firm = [$50,000 (0.65)]/0.14 = $232,142.86 ignoring personal tax, Tax shield = 0.35 x $100,000 = $35,000 Hence, total value = $232,142.86 + $35,000 = $267,142.86

If personal tax is considered; leverage tax shield value = [1 - ((1 - Tc)(1 - Ts)/(1 - Tb))]B = [1 - ((1 - .35)(1 - .15)/1 - .20))]*$100,000 = $30,937.50 Total Value = $232,142.86 + $30,937.50 = $263,080.36 WACC = (S/VL) x Rs + (B/VL) x RB(1-tc) Ignoring personal tax, Rs = R0 + (B/S)x(1-tc)x(R0 RB) = 0.14 + [100,000/(267,142.86 100,000)]x(0.65) X (0.14 0.10) = 0.14 + 0.0155 = 0.15555 Hence, WACC = (167,142.86/267,142.86) x 0.15555 + (100,000/267,142.86) x 0.10(1-0.35) = 0.09733 + 0.024332 = 0.1217
QUESTION 3 FPE Bhd. and FPS Bhd. are identical companies except that FPS is more levered. Unfortunately, both companies are expected to remain in business for one more year. The following information is available. FPE 1.23 RM400,000 RM800,000 RM400,000 FPS 1.22 RM600,000 RM800,000 RM400,000

Z-score Debt due in one year Probability EBIT in expansion 0.60 EBIT in recession 0.40

Neither companies pay taxes. Assume a discount rate of 12 percent.

Required: (a) Calculate the current values of FPEs debt and equity. (6 marks) FPEs bondholders will receive full amount of debt due in any state, whereas FPSs bondholders will receive only RM400,000 instead of RM600,000 if economy worsens. Thus, CV of FPE debt = [0.6(400,000) + 0.4(400,000)] / 1.12 = 400,000/1.12 = RM357,142.86 CV of FPE equity = [0.6(800,000 - 400,000) + 0.4(400,000 - 400,000)] / 1.12 = 240,000/1.12 = RM214,285.71 (b) What are the current values of FPSs debt and equity? (6 marks) CV of FPS debt = [0.6(600,000) + 0.4(400,000)] / 1.12 = 520,000/1.12 = RM464,285.71 CV of FPS equity = [0.6(800,000 - 600,000) + 0.4(0)] / 1.12 = 120,000/1.12 = RM107,142.86 (c) Determine whether or not FPE and FPS are still identical. (4 marks) Total value of FPE = RM357,142.86 + RM214,285,71 = RM571,428.57 Total value of FPS = RM464,285.71 + RM107,142.86 = RM571,428.57 Based on the total value, FPE and FPS are still identical due to the assumption of no bankruptcy costs and taxes. A. Briefly explain TWO (2) indirect costs of bankruptcy. (4 marks) Impaired ability to conduct business. Firms may suffer a loss of sales due to a decrease in consumer confidence and loss of reliable supplies due to a lack of confidence by suppliers. Incentive to take large risks. When faced with projects of different risk levels, managers acting in the stockholders interest have an incentive to undertake high-risk projects. Incentive to under-invest. If a company is near bankruptcy, stockholders may well be hurt if they contribute equity to a new project, even if the project has a positive NPV.