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GROUP1EXERCISES

PROBLEM1&2:
1. There is a potential conflict of interest between shareholders and managers which give
risetowhatareknownas'agencyproblems'
(a)
Giveexamplesofsomeofthe'agencyproblems'thatcanariseasaresultofthis
potentialconflictofinterest.
(b)
Intheory,shareholdersareexpectedtoexercisecontrolovermanagersthroughthe
annualmeetingortheboardofdirectors.
Inpractice,whymightthesedisciplinarymechanismsnotwork?
Whatothermechanismsareusedinordertoreducepotentialagencyproblems?
2.Therearesomecorporatestrategistswhohavesuggestedthatfirmsfocuson
maximizingmarketshare/earningpershareratherthanmarketvalue.Whatisyourviewof
suchasuggestion?
SOLUTION1&2:
Seetextbookandlecturenotes.
PROBLEM3:
Presentvalues,annuitiesandperpetuities
(a) Whatisthepresentvalueof10,000arisingin1year'stime,assuminga
discountrateof12%?
(b) Whatisthepresentvalueofanannuityofastreamof10annualcashflowsof
10,000each,assumingadiscountrateof12%,withthefirstcashflow
arisingin1year'stime?
(c) Whatisthepresentvalueofanannuityofastreamof10annualcashflowsof
10,000each,assumingadiscountrateof12%,withthefirstcashflow
arisingin2years'time?
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(d) Whatisthepresentvalueofanannuityofastreamof10annualcashflowsof
10,000each,assumingadiscountrateof12%,withthefirstcashflow
arisingtoday?

(e) Whatisthepresentvalueofperpetuityof10.000perannum,assuminga
discountrateof12%,withthefirstcashflowarisingin1year'stime?
(f) Whatisthepresentvalueofperpetuityof10,000perannum,assuminga
discountrateof12%,withthefirstcashflowarisingin2year'stime?
(g) Whatisthepresentvalueofperpetuityof10.000perannum,assuminga
discountrateof12%,withthefirstcashflowarisingtoday?

SOLUTION3:

(a)
PV=10,000/1.12=8,929
(b)
PV=10,000x5.650=56,500
(c)
PV=56,500/1.12=50,446
This is a 10year annuity but starting 1 yearlate. Therefore,thevalueoftheannuityisas
atYear1andweneedtodiscountbacktogivethePV.
(d) PV=10,000+(10,000x5.328)=63,280
This iseffectively a 9year annuity of 10,000 plus 10,000 today (ie already in PV
terms),
(e)

PV=10,000/0.12=83,333

(f)

PV=83,333/1.12=74,405

(g)

PV=10,000+83,333=93,333

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GROUP2EXERCISES
PROBLEM1:
A company has 100m of debentures with a 10% coupon rate, which are redeemable at a
10%premiumin5year'stime.Therateofcorporationtaxis30%.
Required
Calculate the market value of these debentures assuming debenture holders require a rate
ofreturnof8%perannumbeforetax.
SOLUTION1:
Market value of debt is found usingthedividendvaluationmodel:futurecashreceiptsfor
the debenture holders arediscountedatthedebentureholders'requiredrateofreturn.(The
rate of corporation tax is irrelevant). Theamountofinterestperannumis10%x100m=
10m. There is alsoaredemptionpremiumof10%(i.e.10%100m=10m)in 5 years'
time.Thereforethetotalcashreceivedbydebentureholdersinyear5is120m.

Cashflow
Discount
factor
PV
TotalPV

1
10m

0.926
9.26
114.84

2
10m

0.857
8.57

3
10m

0.794
7.94

4
10m

0.735
7.35

5
120m

0.681
81.72

Thereforemarketvalue=114.84m
PROBLEM2:
ABC plc is a mediumsizedcompanythatislisted on thestockmarket.Thecompanyhasa
yearend of 31st December. The company's earnings per share (EPS) and dividends per
share(DPS)forthelast5yearsareasfollows:

2005

2004

2003

2002

2001

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EPS(p)
DPS(p)

140
82

136
81

131
79

127
78

122
77

Dividends are paid on 31st December each year. If the current dividend policy is
maintained, the directors estimate that annual growth in earningsanddividendswillbeno
betterthantheaveragecompoundgrowthinearningsoverthepast5years.
ABC plc is reluctant to take on debt at the present time to finance further growth. The
company is therefore contemplating a change in its dividend policy and total investment
plans to allow for 50% of its earnings to be retained for identified capital expenditure
projects, which are estimated to have a posttax return of 15%. The cost of equity for the
companyis12%.
Required
(a) Using the dividend valuation model, calculate the share price which might be
expectedbythemarket:

(i)ifthecompanydoesnotannounceachangeindividendpolicy.
(ii)ifthecompanydoesannounceachangeindividendpolicy.
(Note: For both parts (i) and (ii), you should assume that dividends will grow from their
currentlevelof82ppershare).
(b)

Commentonthelimitationsofthemodelsyouhaveusedinpart(a).

(c) Discussthereasonswhythesharepricemightreactdifferentlyfromthemarket's
expectations.

SOLUTION2:

ABCplc
(a)
(i)Currentdividendpolicy
Averagecompoundgrowthrateofdividendsoverpast5years=
g=(4throotof140/122)1=3.5%
Shareprice(at1stJanuary2006)=Dividend2006
Keg
=(82x1.035)/(0.120.035)
=998.5p
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(ii)Newdividendpolicy
growthrate=returnonequityx'plowback'rate
g=15%x50%=7.5%

Shareprice(at1stJanuary2006) =Dividend2006
Keg

=(82x1.075)/(0.120.075)

=l,958.9p

PROBLEM:

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PA plc is all equityfinancedandhas1millionsharesinissue.Thefollowingfinancial


informationisrelevant(allvaluesinpence):

Year
2001
2002
2003
2004
2005

EPS
42
46
51
55
62

DPS
17
18
20
22
25

Investment analysts have reevaluated the company's prospects and estimate the
company's earnings and dividends will grow at 25% for the next 2 years. Thereafter,
earnings are likely to increase at a lower annual rateof10%.Ifthisreductioninearnings
growth occurs, the analysts consider it likely that the dividend payout ratio will be
increasedto50%.

Thecompany'scostofequityis18%.

Required
Using the dividend valuation model, calculate the estimated share price which the
analystsnowexpectforPAplc.

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SOLUTION3:

PAplc

2005
do

2006
d1

2007
d2

2008
D3

DPS
25
31.25
39.06
EPS
62
77.5
96.88
Growth
25%
25%
rate%
NBdiscountrate=costofequity=18%

53.28
106.56
10%

200
9
d4
58.61
117.22
10%

PVofDividend2006

PVofDividend2007

=31.25x0.847=26.47

Valueofdividendsfrom2008toinfinity

=Dividend2008
Keg

20
10
d5
64.47
128.94
10%

=39.06x0.718=28.05

=53.28.
(0.180.1)

=666p

Thisisthevalueasat31sDecember2007
Therefore,needtodiscountatyear2discountfactorforcostofequityof18%:
Valueat1stJanuary2006
=666x0.718
=478.19
TotalPVoffuturedividends=26.47+28.05+478.19=532.70

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GROUP3EXERCISES

PROBLEM1:
HickLimitedisconsideringinvestinginanewproject,forwhichthefollowing
informationisavailable:
000

Initialinvestment

Lifeofproject

Estimatedannualcashflows:

Year1
Year2
Year3
Year4

450

Residualvalue

30

4years

150
300
100
100

Therateofcorporationtaxis30%.
Required:
Evaluatethefinancialviabilityoftheaboveprojectusingthefollowingtechniques:
i)
payback
ii)
theaccountingrateofreturn
iii)
netpresentvalue(assumingacostofcapital10%)
iv)
internalrateofreturn
Clearlystatetheassumptionsmade.

SOLUTION1:

a.
Timevalueofmoneyrelatestotheideathat1todayisnotequalinvalueto1inthe
future
Timevalueofmoneyissaidtohavethreecomponents
oTheimpatiencetoconsumeorpuretimevalueofmoney
oInflation
oRisk
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Thereforeitisnotappropriatetosimplyaddorcomparesfromdifferenttimeperiods
Futuresarethereforetranslatedintopresentvalue

b.

(i)

Cashflow
Investment
=(450,000)
Year1
=150,000
Year2
=300,000
Thereforepaybackequals2years

Cumulative
(450,000)
(300,000)
0

(ii)

ARRisbasedonprofitswhich=cashflowdepreciation
Straightlinedepreciation=(450,00030,000)/4=105,000p.a.
UsingannualbasisofARR
Year1=(45/450)x100% =10%
Year2=(195/345)x100% =56.5%
Year3=(5/240)x100% =2%
Year4=(5/135)x100% =3.7%
UsingtotalinvestmentbasisofARR
{[(45+19555)/4]/450}xl00%=57.5/450=12.8%
UsingaverageinvestmentbasisofARR
{57.5/[(450+30)/2]}=24%

(iii)

Year
0
1
2
3
4
NPV

Cashflow

Discount
factor
1
0.909
0.826
0.751
0.683

(450)
150
300
100
130

PV
450.00
136.35
247.80
75.10
88.79
98.04

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(iv)
Trydiscountrateof25%

Year

Cashflow

0
1
2
3
4
NPV

(450)
150
300
100
130

Discount
factor
1
0.800
0.640
0.512
0.410

PV
(450.0)
120.0
192.0
51.2
53.3
(33.5)

Usinglinearinterpolation(orgraphicalmethod)IRRcanbeestimated:
98.04+33.5 =98.04
0.250.1
(x0.1)
Rearranginggives:

(x0.1)

=98.04x0.15
98.04+33.5

Thereforex=0.11+0.1=21%approx.

c.Seetextbookandlecturenotes.

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PROBLEM2:
A project requires an initial investment of 120,000 and is expected to produce the
followingnetcashinflows:

Year1
50,000
Year2
25,000
Year3
25,000
Year4
25,000
Year5
30,000

Thediscountrateis8%
Required

Evaluatethefinancialviabilityofthisprojectusingthefollowingmethods:
a)
payback
b)
accountingrateofreturn
c)
netpresentvalue
d)
internalrateofreturn

SOLUTION2:

a.

(i)

Cashflow
Cumulative
Investment
=(120,000)
(120,000)
Year1
=50,000
(70,000)
Year2
=25,000
(45,000)
Year3
=25,000
(20,000)

Year4
=25,000
5,000payback
Thereforepayback=3.8years(3years+20,000/25,000)

(ii)

ARRisbasedonprofitswhich=cashflowdepreciation
Straightlinedepreciation=(120,000)/5=24,000p.a.
UsingannualbasisofARR
Year1=(26/120)x100%=21.7%
Year2=(1/96)x100%=1.0%
Year3=(1/72)x100%=1.4%
Year4=(1/48)x100%=2.1%
Year5=(6/24)x100%=25.0%
UsingtotalinvestmentbasisofARR
{[(26+1+1+1+6)/5]/120}X100%=7/120=5.8%

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UsingaverageinvestmentbasisofARR
{7/[(120)/2]}=11.7%
(iii)
Year

Cashflow

0
1
2
3
4
5
NPV

(120)
50
25
25
25
30

Discount
factor
1
0.926
0.857
0,794
0.735
0.681

PV
120.0
46.3
21.4
19.8
18.4
20.4
6.3

(iv)
Trydiscountrateof15%

Year

Cashflow

0
1
2
3
4
5
NPV

(120)
50
25
25
25
30

Discount
factor
1
0.870
0.756
0.658
0.572
0.497

PV
120.0
43.5
18.9
16.4
14.3
14.9
12.0

Usinglinearinterpolation(orgraphicalmethod)IRRcanbeestimated:

6.3+12.0=6.3
0.150.08(x0.08)
Rearranginggives:

(x0.08)=6.3x0.07
6.3+12.0

Thereforex=0.08+0.024=10.4%approx.
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GROUP4EXERCISES

PROBLEM1:

ProjectPoldavia
Abuildingmaterialscompanyhasidentifiedanopportunitytoinvestinanewcement
plantinPoldavia,detailsofwhichareprovidedbelow:
Initialinvestmentrequired
NetsalesexpectedinYear1
Salesgrowthrate
Operatingprofitmargin
Taxrate
Workingcapitalinvestment
Costofcapital

40m(tobedepreciatedover20years)
100m
5%perannumforthefirst5years/zerogrowth
thereafter
10%forthefirst3yearsand12%thereafter
(excludingdepreciation)
30%.
10%ofthefollowingyear'sNetSales(required
atthestartofeachyear)
8.5%

The amount of sustaining capital expenditure required is estimated to be equal to the


amountofdepreciationchargedperannum.
The Poldavia plant will initially impact on the business of the Company's plant in nearby
Polgaria. It is estimated that the lost exports to Poldavia will result in lost contribution
(beforetax)tothePolgarianplantof8minyear1,8minyear2and3minyear3.
The investment will partly be financed by a 10year bank loan of 30m at an interest rate
of5%beforetax.
In addition to the 40m capital investment required, a number of feasibility and
marketresearchstudieshavealreadybeencarriedoutatatotalcostof2m.
Requirement
Calculate the net present value of this investment. (You may assume that the new
Poldavia plant will have an infinite life, even though it will be depreciated over 20
yearsforaccountingandtaxpurposes).

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SOLUTION1:

ProjectPoldavia
NetPresentValueAnalysis

Allamountsin'000

Year0

Year1

Year2

Year3

Year4

Year5

Stabilised

NetSales
Salesgrowth%

100,000

105,000
5%

110,250
5%

115,763
5%

121,551
5%

121,551

OperatingProfit(OP)before
depreciationOPmargin(ex
depn)%

10,000

10%

10,500

10%

11,025

10%

13,892

12%

14,586

12%

14,586

12%

LostContribution

(8,000)

(8,000)

(3,000)

Depreciation

(2,000)

(2,000)

(2,000)

(2,000)

(2,000)

(2,000)

OperatingProfitBeforeTax

500

6,025

11,892

12,586

12,586

Tax(30%)

(150)

(1,808)

(3,568)

(3,776)

(3,776)

NOPAT

350

4,217

8,324

8,810

8,810

2,000

2,000

2,000

2,000

2,000

(2,000)

(2,000)

(2,000)

(2,000)

(2,000)

(525)

(551)

(579)

8,810

Initialinvestment
Adddepreciation
Lesssustainingcapex,
Workingcapitalchange
(working1)
Freecashflow
Terminalvalue(working2)

(40,000)
2,000

(2,000)

(10,000) (500)

(50,000) (500)..

(175)

3,666

7,745

8,810

103,647

Totalamounttodiscount

(50,000)

(500)

(175)

3,666

7,745

112,457

Discountrate

0.922

0.849

0.783

0.722

0.665

Presentvalue

(50,000)

(461)

(149)

2,870

5,592

74,784

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NetPresentValue

32,636

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Workings:
1.Changeinworkingcapital

NetSales
Workingcapitalrequired
Changeinworkingcapital

Year0

Year1

Year2

Year3

Year4

Year5

100,000

105,00
0

110,250

115,763

121,55
1

10,000

10,500

11,025

11,576

12,155

12,155

10,000

500

525

551

579

2.Terminalvalue
Terminalvalue=stabilizedcashflowx(1+growthrate)/(discountrategrowthrate)
Inthiscase,perpetuitygrowthrate=0
Therefore:
Terminalvalue=8,810/0.085=103,647

PROBLEM2:

Emperor'sClothesFashions(ECF)
ECFcaninvest5millioninanewplantforproducinginvisiblemakeup.Theplanthasan
expectedlifeof5years,andexpectedsalesare6millionjarsofmakeupayear.Fixedcosts
are2millionayear,andvariablecostsare1perjar.Theproductwillbepriceat2per
jar.Theplantwillbedepreciatedstraightlineover5yearstoasalvagevalueofzero.The
opportunitycostofcapitalis10%,andthetaxrateis40%.

a. WhatisprojectNPVunderthesebasecaseassumptions?

b. WhatisNPVifvariablecoststurnouttobe1.20perjar?

c. WhatisNPViffixedcoststurnouttobe1.5millionperyear?

d. AtwhatpriceperjarwouldprojectNPVequalzero?

SOLUTION2:

ECF
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Revenue=Pricexquantity=26million=12million
Totalcosts=Variablecost+fixedcost=(16million)+2million=8million
Depreciationexpense=5million/5years=1millionperyear
Therefore,profitperannumbeforetax=12m8m1m=3m
Therefore,taxchargeperannum=3mx40%=1.2m
Profitaftertax=3m1.2m=1.8m

Aftertaxcashflow=profitaftertax+depreciation=1.8m+1m=2.8m
a.NPV=5million+[2.8millionxannuityfactor(10%,5years)]
=5+(2.83.791)=5.6million

b.Ifvariablecost=1.20,thentotalcostsincreaseto:
(1.206million)+2million=9.2million
Profitbeforetaxperannum=12m9.2m1m=1.8m
Profitaftertax=60%x1.8m=1.08million
Aftertaxcashflow=1.08m+1m=2.08m
NPV=5million+[2.08millionx3.791]=2.9million
c.

Iffixedcosts=1.5million,totalcostsfallto:
(16million)+1.5million=7.5million
Profitbeforetaxperannum=12m7.5m1m=3.5m
Profitaftertax=60%x3.5m=2.1m
Cashflow=2.1m+1m=3.1m
NPV=5million+[3.1millionx3.791]=6.8million

d.

CallPthepriceperjar.Then:
Revenue=P6million
Expense=(1x6million)+2million=8million
Givendepreciationistaxdeductible,theseresultsinataxsavingof1mx40%=
0.4m
Therefore,cashflowaftertaxperannumcanbeexpressedasfollows:
Cashflow=[(60%x(6P8)]+(0.4)=3.6P4.4
NPV=5+[(3.6P4.4)xannuityfactor(10%,5years)]
=5+[(3.6P4.4)x3.791]=21.680+13.648P
Therefore,NPV=0whenP=1.59perjar

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PROBLEM3:

DiamondLtd
DiamondLtdhas1mtoinvestandhaveidentifiedthefollowingfourprojects:

Project
A
B
C
D

InvestmentOutlay
400,000
600,000
300,000
250,000

NetPresentValue
+100,000
+125,000
+90,000
+40,000

Required
Assuming each project is infinitely divisible and the projects are not mutually
exclusive,inwhichprojectsshouldDiamondLtdinvest?

SOLUTION3:

DiamondLtd
RankprojectsonbasisofNPVperofinvestmentrequired

Project
A
B
C
D

InvestmentOutlay NetPresent
Value
400,000
+100,000
600,000
+125,000
300,000
+90,000
250,000
+40,000

NPVper

Ranking

0,25
0.208
0.3
0.16

2
3
1
4

Allocateavailablefundsaccordingly

Project
C
A

Fundsused
300,000
400,000

NPV
90,000
100,000

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300,000(balance)
1,000,000

62,500(=125,000)
252,500

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GROUP5EXERCISES
Problem1:
Consider the following data for the returns on shares of the swimming pool owned by
SplashplcandthatoftheIceCreamManufacturingCompany(ICMC):

Event

probability

Splashsharereturn

Hotweather
Modestlywarm
Coldweather

0.2
0.6
0.2
1.0

5
15
20

ICMC
return
30
15
2

share

Required:

a.

Whatistheexpectedreturnofeachofthetwoshares?

b.

Whatisthestandarddeviationofthereturnsofeachofthetwoshares?

c.
Calculate the expected returns and standard deviation of the following
portfolios.

Portfolio

Proportion of funds
investedinICMC

A
B
C

0.80
0.50
0.25

Proportion of
funds invested
inSplash
0.20
0.50
0.75

d. Draw a riskreturn line using the data you have generated from a, b and c. (In
addition, you may also assume that the minimum standard deviation possible from a
portfolioofSplashandICMCsharesis0.62,whichgivesanexpectedreturnof14.5%).

SOLUTION1:

a.
Ri(%)
Rs(%)
piorps
RiPi
Rsps
30
5
0.2'
6.0
1.0
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15
2

15
20

b.
(RiE(Ri))2pi
42.63
0.10
35.91
2=78.64
=8.87%

0.6
0.2
Expected
return

9.0
9.0
0.4
4.0
E(Ri)=15.4% E(RS)=14.0%

(RsE(RS))2ps
16.2
0.6
7.2
=24.0
=4.9%

c.
[RiE(Ri)][RsE(RS)]pi
26.28
0.24
16.08
42.60
PortfolioA:
Expectedreturn:0.815.4+0.214=15.12%
Standarddeviation:
(0.8278.64+0.22x24+2x0.8x0.242.6)I/2=6.1%
PortfolioB:
Expectedreturn:0.515.4+0.514=14.7%

Standarddeviation:
(0.5278.64+0.52x24+2x0.50.542.6)=2.1%
PortfolioC:
Expectedreturn:0.2515.4+0.7514=14.35%

Standarddeviation:
(0.25278.64+0.75224+20.250.7542.60)=1.56%

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d.

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GROUP6EXERCISES

PROBLEM1:

Delawareplc

ExtractsfromDelawareplc'smostrecentbalancesheetareasfollows:
12%IrredeemableDebentures
OrdinaryShareCapital(1shares)
SharePremiumAccount
Reserves

000
4,000
8,000
2,000
6,000
16,000

An annual ordinary dividend of 20p per share has just been paid. In the past, ordinary
dividends have grown at a rate of 10% per annum and this rate of growth is expected to
continue. Annual interesthasrecentlybeenpaidonthedebentures.Theordinarysharesare
currently quoted at 2.75 and the debentures at 80 per cent (i.e. 80 per 100 nominal
value).

Therateofcorporationtaxis30%.

Required

CalculateDelaware'sWeightedAverageCostofCapital.

SOLUTION1:

Delawareplc

=18%

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=10.5%
WACC:

MarketValue

Equity
Debt

22m
3.2m
25.2m

87%
13%

CostofCapital
%
18
10.5
WACC=

WeightedCost
15.7
1.3
17.0%

PROBLEM2:

Herbertplc
YouhavebeencalledinasaconsultantforHerbertplc,asportinggoodsretailfirm,which
isexaminingitsdebtpolicy.Thefirmiscurrentlyhasabalancesheetasflows
Allamountsinm
Longtermbonds
Equity
Total

100
500
600

Fixedassets
Currentassets
Total

500
100
600

Thefirm'sincomestatementisgivenasfollows(allinm):

Revenues
Costofgoodssold
Depreciation
EBIT
Longterminterest
Earningbeforetax
Taxes
NetIncome

250
175
25
50
10
40
16
24

The firm currently has 100m shares outstanding, selling at a market price of 5 per share
and the bonds are selling at their book value. The firm's current beta is 1.12, the rate of
returnongovernmenttreasurybondsis7%andthemarketriskpremiumis5.5%.
a. Whatisthefirm'scurrentcostofequity?
b. Whatisthefirm'scurrentcostofdebt?(Youmayassumetherateof
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corporationtaxis40%).
c. Whatisthefirm'scurrentweightedaveragecostofcapital?
d. AssumethatmanagementofHerbertplcisconsideringdoingadebtequity
swap(i.e.,borrowingenoughmoneytobuyback70msharesofstockat5per
share).Itisbelievedthatthisswapwilllowerthefirm'sratingtoCandraise
theinterestrateonthecompany'sdebtto15%andthebetaofequityis
expectedtoincreaseto2.8.
Whatisthefirm'snewweightedaveragecostofcapital?

SOLUTION2:

Herbertplc
a. Currentcostofequity=7%+1.12(5.5%)=13.16%
b. Currentpretaxcostofdebt=InterestExpenses/Marketvalueofdebt=10/100
=10%
Theaftertaxcostofdebt=10%(10.4)=6%.
c.

Thefirmscurrentcostofcapital(WACC)=D/Vrdebt(1T)+E/Vrequity
Whererdebtisthepretaxcostofdebtandrdebt(1T)istheaftertaxcostofdebt.
ThusWACC=13.16%(500/600)+6%(100/600)=11.97%.

d. Ifthefirmborrows350millionandbuysbackshares
Newdebt=450m
Newequity=150m
Thecostofnewequity=7%+2.80(5.5%)=22.40%
Theaftertaxcostofdebt=15%(10.4)=9%
WACC=22.40%(150/600)+9%(450/600)=12.35%

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PROBLEM3:

WestLtd
WestLtdisanunquotedcompany.TherecentlyappointedFinanceDirectorhasaskedfor
yourassistanceinobtainingacostofcapitalthatWestLtdcanusetoappraiseits
longterminvestmentopportunities.

Youhavebeenprovidedwiththefollowinginformation:

2million25pordinarysharesvaluedat87p
Theannualdividendof180,000,whichrepresents70%oftheamountthatwasavailable
fordistribution,hasjustbeenpaid.Thecompanyexpectstoachievearateofreturnof
26%onitsretainedprofits.

1million9%preferencesharesofl0pvaluedat80,000cumdiv.

lm8%irredeemabledebentures.Debentureholdersrequirearateofreturnof10%.

Therateofcorporationtaxis30%.

Required

CalculateforWestLtdits

(a)
costofequity

(b)
costofpreferenceshares

(c)
marketvalueofdebentures

(d)
costofdebentures

(e)
weightedaveragecostofcapital

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SOLUTION3:

WestLtd
(a) Costofequity
g=rateofreturnonequityxplowbackratio
=26%30%=7.8%

=19.0%
(b) Costofpreferenceshare=Dividends
Marketvalue(ediv)

=12.7%
(c) Marketvalueofdebentures=Interest
Debentureholders'requiredrateofreturn

=0.8m,
(d) Costofdebentures=10%(1taxrate)=10%(10.3)
=7%
(e) WACC:

Equity
Prefshares

MarketValue
1.740m
0.07lm

66.67c
2.7%

CostofCapital
%
19
12.7

Weighted
Cost
12.7
0.4

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Debt

0.80m
2.611m

30.6%

7
WACC=

2.1
15.2%

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GROUP7EXERCISES
PROBLEM1:
ALtdwishestobuyBLtdforlm.Thecurrentbalancesheetpositionsofbothcompanies
areasfollows:

FixedAssets
Factory
Machinery

NetCurrentAssets

FinancedBy
ShareCapital
Reserves

ALtd
000

BLtd
000

450
250
700
750
1,450

400
400
600
1,000

150
1,300
1,450

100
900
1,000

A Ltd makes pretax profits of 200,00 per year. The owner of A Ltd has 150,000 of
cash, lives in a house worth 600,000 subject to a mortgage of 250,000, and has life
assurance policies and investments worth 180,000. After the takeover it isestimatedthat
the combined companies will produce a cash flow of 250,000 for the service of debt,
besidesprovidingtheownerwithasalaryanddividends.
Requirement
Recommendanappropriatefinancingpackage.
SOLUTION1:

ALTDBUYSBLTD

1misonlythebalancesheetvalueofBLtd.ItispossiblethatALtdmayneedto
paymorethanthistoacquireBLtd'sshares!

Wouldbeinterestingtoknowwhetherthereisanysurpluscashisinthebalance
sheetofALtd,andwhethertheworkingcapitalofALtdcanbe'squeezed'(eg

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throughbetterstockanddebtorsmanagement)tomakefundsavailablefor
financingthisacquisition

TheownerofALtdshouldonlyreallyconsiderusinghisownfundsandre
mortgaginghisownpropertyafterhehasexhaustedallopportunitiesforraising
financeviathecompany

ALtdcurrentlyhasnogearing,has700,000offixedassetstoofferassecurity
ondebt,andhascashflowsof250,000perannumtoservicethedebt.The
companythereforehastheabilitytoraiseasignificantamountofdebt.

Assuminglmrequired,thenapossiblefinancemixcouldbe250kofcash
(ideallyfromworkingcapitaloralternativelyfromtheownerofALtd'sown
fundsplusremortgageofhouse),then750kofdebtsecuredonassetsofALtd
andBLtdcombined

PROBLEM2:
A group intends to sell off a division. The division is run by two managers (one in
production and one in marketing) and has been breaking even. However, the managers
reckonthatitcouldproduce profitof100,000ayearifheadofficechargeswereremoved
they also foresee substantial growth. The group is prepared to sell the division for
400,000 to existing management. Net assets are 600,000 including a freehold factory
valued at 320.000. The managers can raise 100,000 through second mortgages and
savings.
Requirement
Recommendanappropriatefinancingpackage.
SOLUTION2:

MBO
Management Buy Out's (MBO's) generally involve a substantial amount of cash
injectionfromthemanagerstoshowcommitmentandobtainownership
Mayneedtoraisemorethan400,000tohelpfinancethefuturegrowth
There is a gap between what the managers can raise (100,000) and the minimum
amountrequired(400,000)
Managers may be reluctant tobringinnewequityasthiswilldilutetheircontrolof
thenewcompany
The freehold factory may provide security for senior debt.Thecompanyshouldbe
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able to raise around 80% of the market value of the factory's market value(80%x
320,000=256,000)
The profit forecasts suggest that the companywillgeneratesufficientcashflowsto
servicethedebtinterest
The managers may look to Venture Capital finance to help fill the financing gap
andstrengthenthemanagementteam.
Assuming 400,000 will be sufficient initially, suggestion is for the managers to
input 100,000,VC'stoinput50,000inexchangeforaplaceontheboard,andfor
seniordebtof250.000
PROBLEM3:

A mediumsized company wants to expand, but isheld backbyhighgearing.Theplanned


expansion is forecast to raise pretax profit from 600,000 to 900,000, but initial tooling
costs for the increased manufacturing capacity will amount to 800,000. Bank overdraft
facilitiesof1,400,000arecurrentlyfullyused.Thecurrentpositionisasfollows:

000
000

FixedAssets
3000
CurrentAssets
4,200

Creditors:amountsfallingduewithin1year
TradeCreditors
1,800
Overdraft
1,400
3,200

NetCurrentAssets
1,000
4,000
TermLoan
1,600
2,400
FinancedBy
ShareCapital
400
Reserves
2,000
2,400

Requirement

Recommendanappropriatefinancingpackage.

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SOLUTION3:

EXPANSION

800,000 required cannot be supplied by short term financing as overdraft has


reacheditslimits
Gearing including overdraft is already high unlikely to be able to raise more
seniordebt.Juniordebtmightbepossiblebutinterestratewouldbeexpensive.
Unlikelytobemuchsecuritylefttoofferforthenewfinancerequired
Can the company's working capital be 'squeezed' (e.g. through better stock and
debtorsmanagement)tomakefundsavailableforfinancingtheexpansion?
Raising new equity via rights issue might be a possibilitydependinguponwhether
current shareholders are willingandabletoinvestfurther.Thecurrentshareholders
might be reluctant for finance to come from new shareholders (e.g. from Venture
Capital)asthiswillreducetheircontrolofthecompany

Suggestion the companymightseektorestructureitsdebttoconverttheoverdraft


into a longerterm loan. The company might also consider a sale and leaseback of
itsproperty.

PROBLEM4:

RightsIssue
RIplchas100millionsharesinissue.Itwishestoraise25mviarightsissue.Itsshares
arecurrentlytradingatapriceof120pinthestockmarket.
RIhasdecidedtoraisethe25mbyissuing25madditionalsharesatasubscriptionprice
of1pershare.

FredcurrentlyownslmsharesinRIplcandhaslmofcashinthebank.

Requirement

(a)

(b)

Calculatethetheoreticalexrightsshareprice.
ShowtheeffectonFred'swealthifhedecidesto:
i.Donothing
ii.Takeuptherights
iii.Selltherights

(c) Whateffect,ifany,doesthelevelofpricediscountdecisionhaveonthewealthof
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shareholders?(Forexample,woulditmakeanydifferenceif50mshareswere
soldatasubscriptionpriceof50p?).

SOLUTION4:

RIGHTSISSUE

(a)Given25msharestobeissuedrelativetothe100msharesalreadyinissue,thismeans
thiswillbea1for4rightsissue.
Theoreticalexrightsprice=MVbeforerights+cashraised
No.ofsharesaftertherights
=(1.20x100m)+25
125m
=1.16
This assumes the new funds raised by the company will be invested at zero Net Present
Value.
(b)EffectonFred'swealthif:
(i) Doesnothing

Shares(lm1.2)
Cash

Before
1.2m
1.0m
2.2m

(lm1.16)
Cash

After
1.16m
1.00m
2.16m

Fredwouldthereforebe40,000worseoff.

(ii) Takesuprights
Before
1.2m
(l.25m1.16)
1.0m
Cash(10.25)
2.2m
TherewouldthereforebenoeffectonFred'swealth.
(iii) Selltherights
Shares(lm1.2)
Cash

Shares(lm1.2)
Cash

Before
1.2m
1.0m
2.2m

After
1.45m
0.75m
2.20m

After
(lm1.16)
1.16m
Cash(1+(0.2516p*) 1.04m
2.20m

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TherewouldthereforebenoeffectonFred'swealth.

*Valueoftherights=Exrightspricesubscriptionprice=1.161.00=16ppershare

(c) There will be no effect on shareholders' wealth if a different combination of price and
number of shares is issued to raise the required 25m. (This can be proved byreworking
(b)abovefora50mshareissueatasubscriptionpriceof50p).

Thepricediscountisonlyrelevantwherethereisconcernthataftertherightsissueis
announcedbutbeforeittakesplace,thesharepricemightfallbeneaththesubscription
price.Insuchcircumstances,therightsissuewouldfailasnoonewouldtakeuptherights
offer

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GROUP8EXERCISES

PROBLEM1:

MSPLTD
MSP is a private limited company with intentions of obtaining a stock marketlistingin
the near future. The company is wholly equity financed at present but the directors are
consideringanewcapitalstructurepriortoitbecomingalistedcompany.

MSP operates in an industry where the average asset beta is 1.2 (i.e. beta with zero
gearing). The company's business risk is estimatedtobesimilartothatoftheindustryasa
whole. The current level of earnings before interest and tax is 400,000. This earnings
levelisexpectedtobemaintainedfortheforeseeablefuture.
The rate of return on risk less assets is at present 10% and the return on the market
portfolio is 15%. These rates are posttax and are expected to remain constant for the
foreseeablefuture.
MSP is considering introducing debt into its capital structure by one of the following
methods:
(1)
(2)

500,00010%debenturesatpar,securedonthecompany'slandandbuildings
1,000,00012%unsecuredloanstockatpar

The rate of corporation tax is expected to remain at 33% and interest on debt is tax
deductible.
Required
(a) Calculateforeachofthetwooptions:

(i)valuesofequityandthetotalmarketvalueofthefirm
(ii)debt/equityratios
(iii)thecostofequity
(b) Listthemainproblemsandcostswhichmightariseforacompanyexperiencinga
periodofseverefinancialdifficulties.

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SOLUTION1:
(a)
WewilluseVg=Vu+DT
Firstly,calculatetheungearedvalueofthebusiness,Vu
Estimatedcashflowaftertax(toperpetuity)=400,000x(10.33)=268,000
DiscountrateusingCAPM=10%+1.2(15%10%)=16%
Vu=268,000/0.16=1,675,000
500,000debenture
(i) Vg=1,675,000+500,000x0.33=1,840,000,thereforeequityvalueis
1,840,000500,000=1,340,000
(ii) Gearing=500,000/1,340,000=0.37
(iii) Ke=d/P0
Dividend=(400,00050,000)x0.67=234,500
Thereforeke=234,500/1,340,000=17.5%
1,000,000debenture
(i) Vg=1,675,000+1,000,000x0.33=2,005,000,thereforeequityvalueis
2,005,0001,000,000=1,005,000
(ii) Gearing=1,000,000/1,005,000=0.99
(iii) Ke=d/PO
Dividend=(400,000120,000)0.67=187,600
Thereforeke=187,600/1,005,000=18.7%
Answerstopart(b)arewellcoveredinthetextbookandlecturenotes.

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PROBLEM2:

CapitalStructure
"Capitalstructurecanhavenoinfluenceonthevalueofthefirm'.
Discussthisstatementandcommentbrieflyonthepracticalfactorswhichacompany
mighttakeintoaccountwhendeterminingitscapitalstructure.

PROBLEM3:

DividendPolicy
'Dividendpolicycanhavenoinfluenceonthevalueofthefirm'.
Discussthisstatementandcommentbrieflyonthepracticalfactorswhichacompany
mighttakeintoaccountwhendeterminingitsdividendpolicy.
SOLUTION2&3:
Answerstoproblem2and3arewellcoveredinthetextbookandlecturenotes.

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