G ROUP 1 E XERCISES

PROBLEM 1 & 2:

1. There is a potential conflict of interest between shareholders and managers which give
rise to what are known as 'agency problems'

(a) Give examples of some of the 'agency problems' that can arise as a result of this
potential conflict of interest.

(b) In theory, shareholders are expected to exercise control over managers through the
annual meeting or the board of directors.

In practice, why might these disciplinary mechanisms not work?

What other mechanisms are used in order to reduce potential agency problems?

2. There are some corporate strategists who have suggested that firms focus on
maximizing market share rather than market value. What is your view of such a
suggestion?

SOLUTION 1 & 2:

See textbook.

PROBLEM 3:

Present values, annuities and perpetuities

(a) What is the present value of 10,000 arising in 1 year's time, assuming a
discount rate of 12%?

(b) What is the present value of an annuity of a stream of 10 annual cash flows of
10,000 each, assuming a discount rate of 12%, with the first cash flow
arising in 1 year's time?

(c) What is the present value of an annuity of a stream of 10 annual cash flows of
10,000 each, assuming a discount rate of 12%, with the first cash flow
arising in 2 years' time?

(d) What is the present value of an annuity of a stream of 10 annual cash flows of

Page -1
 10,000 each, assuming a discount rate of 12%, with the first cash flow
arising today?

(e) What is the present value of perpetuity of 10.000 per annum, assuming a
discount rate of 12%, with the first cash flow arising in 1 year's time?

(f) What is the present value of perpetuity of 10,000 per annum, assuming a
discount rate of 12%, with the first cash flow arising in 2 year's time?

(g) What is the present value of perpetuity of 10.000 per annum, assuming a
discount rate of 12%, with the first cash flow arising today?

SOLUTION 3:

(a) PV= 10,000/1.12 = 8,929

(b) PV = 10,000 x 5.650 = 56,500

(c) PV = 56,500/1.12 = 50,446

This is a 10-year annuity but starting 1 year late. Therefore, the value of the annuity is as
at Year 1 and we need to discount back to give the PV.

(d) PV = 10,000 + (10,000 x 5.328) = 63,280

This is-effectively a 9-year 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

Page -2
 G ROUP 2 E XERCISES

PROBLEM 1:

A company has 100m of debentures with a 10% coupon rate, which are redeemable at a
10% premium in 5 year's time. The rate of corporation tax is 30%.

Required

Calculate the market value of these debentures assuming debenture holders require a rate of
return of 8% per annum before tax.

SOLUTION 1:

Market value of debt is found using the dividend valuation model: future cash receipts for
the debenture holders are discounted at the debenture holders' required rate of return. (The
rate of corporation tax is irrelevant). The amount of interest per annum is 10% x 100m =
10m. There is also a redemption premium of 10% (i.e. 10% 100m = 10m) in 5 years'
time. Therefore the total cash received by debenture holders in year 5 is 120m.

1 2 3 4 5
Cash flow 10m 10m 10m 10m 120m
Discount
factor 0.926 0.857 0.794 0.735 0.681
PV 9.26 8.57 7.94 7.35 81.72
Total PV 114.84

Therefore market value = 114.84m

PROBLEM 2:

ABC plc is a medium sized company that is listed on the stock market. The company has
a year-end of 31st December. The company's earnings per share (EPS) and dividends per
share (DPS) for the last 5 years are as follows:

2005 2004 2003 2002 2001

EPS (p) 140 136 131 127 122
DPS (p) 82 81 79 78 77

Dividends are paid on 31st December each year. If the current dividend policy is maintained,
Page -3
the directors estimate that annual growth in earnings and dividends will be no better than
the average compound growth in earnings over the past 5 years.

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 post-tax return of 15%. The cost of equity for the
company is 12%.

Required

(a) Using the dividend valuation model, calculate the share price which might be
expected by the market:

(i) if the company does not announce a change in dividend policy.

(ii) if the company does announce a change in dividend policy.

(Note: For both parts (i) and (ii), you should assume that dividends will grow from their
current level of 82p per share).

(b) Comment on the limitations of the models you have used in part (a).

(c) Discuss the reasons why the share price might react differently from the market's
expectations.

SOLUTION 2:

ABC plc

(a)

(i) Current dividend policy

Average compound growth rate of dividends over past 5 years =

g = (4th root of 140/122) - 1 = 3.5%

Share price (at 1st January 2006) = Dividend 2006
K e -g

= (82 x 1.035) / (0.12-0.035)

= 998.5p

Page -4
 (ii) New dividend policy

growth rate = return on equity x 'plowback' rate

g = 15% x 50% = 7.5%

Share price (at 1st January 2006) = Dividend 2006

K e -g

= (82 x 1.075) / (0.12 - 0.075)

= l,958.9p

PROBLEM :

Page -5
PA plc is all equity financed and has 1 million shares in issue. The following financial
information is relevant (all values in pence):

Year EPS DPS

2001 42 17
2002 46 18
2003 51 20
2004 55 22
2005 62 25

Investment analysts have re-evaluated 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 rate of 10%. If this reduction in earnings
growth occurs, the analysts consider it likely that the dividend payout ratio will be
increased to 50%.

The company's cost of equity is 18%.

Required
Using the dividend valuation model, calculate the estimated share price which the analysts
now expect for PA plc.

SOLUTION 3:

Page -6
PA plc

2005 2006 2007 2008 2009 20

do d1 d2 D3 d4 10
DPS 25 31.25 39.06 53.28 58.61 64.47
EPS 62 77.5 96.88 106.56 117.22 128.94
Growth 25% 25% 10% 10% 10%
rate %

NB discount rate = cost of equity =18%

PV of Dividend 2006 = 31.25x0.847 = 26.47

PV of Dividend 2007 = 39.06x0.718 = 28.05

Value of dividends from 2008 to infinity = Dividend 2008

K e -g

= 53.28.
(0.18-0.1)

= 666p

This is the value as at 31s December 2007

Therefore, need to discount at year 2 discount factor for cost of equity of 18%:

Value at 1st January 2006 = 666 x 0.718

= 478.19

Total PV of future dividends = 26.47 + 28.05 + 478.19 = 532.70

Page -7
 G ROUP 3 E XERCISES

PROBLEM 1:

Hick Limited is considering investing in a new project, for which the following
information is available:
000

Initial investment 450

Life of project 4 years

Estimated annual cash flows:

Year 1 150
Year 2 300
Year 3 100
Year 4 100

Residual value 30

The rate of corporation tax is 30%.

Required:

Evaluate the financial viability of the above project using the following techniques:
i) payback
ii) the accounting rate of return
iii) net present value (assuming a cost of capital 10%)
iv) internal rate of return

Clearly state the assumptions made.

SOLUTION 1:

a.

Time value of money relates to the idea that 1 today is not equal in value to 1 in the
future
Time value of money is said to have three components
o The impatience to consume or pure time value of money
o Inflation
o Risk
Therefore it is not appropriate to simply add or compare s from different time periods
Future s are therefore translated into present value

Page -8
b.

(i) Cash flow Cumulative

Investment = (450,000) (450,000)
Year 1 = 150,000 (300,000)
Year 2 = 300,000 0
Therefore payback equals 2 years

(ii)

ARR is based on profits which = cash flow - depreciation

Straight line depreciation = (450,000 - 30,000)/4 = 105,000 p.a.
Using annual basis of ARR
Year 1 = (45/450) x 100% = 10%
Year 2 = (195/345) x 100% = 56.5%
Year 3 = (-5/240) x 100% = -2%
Year 4 = (-5/135) x 100% = -3.7%
Using total investment basis of ARR
{[(45+195 - 5 - 5)/4]/450}xl00% = 57.5/450 = 12.8%
Using average investment basis of ARR
{57.5/[(450 + 30)/2]} =24%

(iii)

Year Cash flow Discount PV

factor
0 (450) 1 -450.00
1 150 0.909 136.35
2 300 0.826 247.80
3 100 0.751 75.10
4 130 0.683 88.79
NPV 98.04

Page -9
 (iv)

Try discount rate of 25%

Year Cash flow Discount PV

factor
0 (450) 1 (450.0)
1 150 0.800 120.0
2 300 0.640 192.0
3 100 0.512 51.2
4 130 0.410 53.3
NPV (33.5)

Using linear interpolation (or graphical method) IRR can be estimated:

98.04+33.5 = 98.04
0.25-0.1 (x - 0.1)

Rearranging gives:

(x - 0.1) = 98.04 x 0.15

98.04 + 33.5

Therefore x = 0.11 + 0.1 = 21 % approx.

c. See textbook and lecture notes.

Page -10
PROBLEM 2:

A project requires an initial investment of 120,000 and is expected to produce the following
net cash inflows:

Year 1 50,000
Year 2 25,000
Year 3 25,000
Year 4 25,000
Year 5 30,000

The discount rate is 8%

Required

Evaluate the financial viability of this project using the following methods:
a) payback
b) accounting rate of return
c) net present value
d) internal rate of return

SOLUTION 2:

a.
(i) Cash flow Cumulative
Investment = (120,000) (120,000)
Year 1 = 50,000 (70,000)
Year 2 = 25,000 (45,000)
Year 3 = 25,000 (20,000)
Year 4 = 25,000 5,000 payback
Therefore payback = 3.8 years (3 years + 20,000/25,000)

(ii)

ARR is based on profits which = cash flow - depreciation

Straight line-depreciation = (120,000)/5 = 24,000 p.a.
Using annual basis of ARR
Year 1 = (26/120) x 100% = 21.7%
Year 2 = (1/96) x 100% = 1.0%
Year 3 = (1/72) x 100% = 1.4%
Year 4 = (1/48) x 100% = 2.1%
Year 5 = (6/24) x 100% =25.0%
Using total investment basis of ARR
{ [(26+1+1+1+6)/5]/120}X100% = 7/120 = 5.8%
Using average investment basis of ARR
{7 / [(120)/2]} = 11.7%
Page -11
(iii)

Year Cash flow Discount PV

factor
0 (120) 1 -120.0
1 50 0.926 46.3
2 25 0.857 21.4
3 25 0,794 19.8
4 25 0.735 18.4
5 30 0.681 20.4
NPV 6.3

(iv)

Try discount rate of 15%

Year Cash flow Discount PV

factor
0 (120) 1 -120.0
1 50 0.870 43.5
2 25 0.756 18.9
3 25 0.658 16.4
4 25 0.572 14.3
5 30 0.497 14.9
NPV -12.0

Using linear interpolation (or graphical method) IRR can be estimated:

6.3 + 12.0 = 6.3

0.15 - 0.08 (x - 0.08)

Rearranging gives:

(x - 0.08) = 6.3 x 0.07

6.3 + 12.0

Therefore x = 0.08 + 0.024 = 10.4% approx.

Page -12
 G ROUP 4 E XERCISES

PROBLEM 1:

Project Poldavia

A building materials company has identified an opportunity to invest in a new cement

plant in Poldavia, details of which are provided below:

Initial investment required 40m (to be depreciated over 20 years)

Net sales expected in Year 1
Sales growth rate
Operating profit margin
Tax rate
Working capital investment
Cost of capital
100m
5% per annum for the first 5 years/zero growth
thereafter
10% for the first 3 years and 12% thereafter
(excluding depreciation)
30% .
10% of the following year's Net Sales (required
at the start of each year)
8.5%

The amount of sustaining capital expenditure required is estimated to be equal to the amount
of depreciation charged per annum.

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
(before tax) to the Polgarian plant of 8m in year 1, 8m in year 2 and 3m in year 3.

The investment will partly be financed by a 10-year bank loan of 30m at an interest rate of
5% before tax.

In addition to the 40m capital investment required, a number of feasibility and market
research studies have already been carried out at a total cost of 2m.

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 years
for accounting and tax purposes).

Page -13
SOLUTION 1:

Project Poldavia
Net Present Value Analysis

All amounts in '000

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Stabilised

Net Sales 105,000 110,250 115,763 121,551

Sales growth % 100,000 121,551
5% 5% 5% 5%
Operating Profit (OP) before 10,000 10,500 11,025 13,892 14,586 14,586
depreciation OP margin (ex
depn)% 10% 10% 10% 12% 12% 12%

Lost Contribution (8,000) (8,000) (3,000)

Depreciation (2,000) (2,000) (2,000) (2,000) (2,000) (2,000)

Operating Profit Before Tax 0 500 6,025 11,892 12,586 12,586

Tax (30%) 0 (150) (1,808) (3,568) (3,776) (3,776)

NOPAT 0 350 4,217 8,324 8,810 8,810

Initial investment
(40,000)
Add depreciation 2,000 2,000 2,000 2,000 2,000 2,000
Less sustaining capex, (2,000) (2,000) (2,000) (2,000) (2,000) (2,000)

Working capital change (10,000) (500) (525) (551) (579) 0 0

(working 1)
Free cash flow
Terminal value (working 2) (50,000) (500).. (175) 3,666 7,745 8,810 8,810
103,647
Total amount to discount (50,000) (500) (175) 3,666 7,745 112,457

Discount rate 1 0.922 0.849 0.783 0.722 0.665

Present value (50,000) (461) (149) 2,870 5,592 74,784

Net Present Value 32,636

Page -14
Workings:

1. Change in working capital

Year0 Year1 Year 2 Year 3 Year 4 Year 5

Net Sales 100,000 105,000 110,250 115,763 121,551

Working capital required 10,000 10,500 11,025 11,576 12,155 12,155

Change in working capital 10,000 500 525 551 579 0

2. Terminal value

Terminal value = stabilized cash flow x (1 + growth rate) / (discount rate - growth rate)

In this case, perpetuity growth rate = 0

Therefore:

Terminal value =8,810/0.085 = 103,647

PROBLEM 2: (HE DIDNT SOLVE IT )

Emperors Clothes Fashions (ECF)

ECF can invest 5 million in a new plant for producing invisible makeup. The plant has
an expected life of 5 years, and expected sales are 6 million jars of makeup a year. Fixed
costs are 2million a year, and variable costs are 1 per jar. The product will be price at 2
per jar. The plant will be depreciated straight-line over 5 years to a salvage value of zero.
The opportunity cost of capital is 10%, and the tax rate is 40%.

d. What is project NPV under these base-case assumptions?

b. What is NPV if variable costs turn out to be 1.20 per jar?

c. What is NPV if fixed costs turn out to be 1.5 million per year?

d. At what price per jar would project NPV equal zero?

Page -15
SOLUTION 2:

ECF

Revenue = Price x quantity = 26 million = 12 million

Total costs = Variable cost + fixed cost = ( 1 6 million) + 2 million = 8 million
Depreciation expense = 5 million/5 years = 1 million per year
Therefore, profit per annum before tax = 12m - 8m - 1m = 3m
Therefore, tax charge per annum = 3m x 40% = 1.2m
Profit after tax = 3m - 1.2m = 1.8m

After tax cash flow = profit after tax + depreciation = 1.8m + 1 m = 2.8m
d. NPV = -5 million + [2.8 million x annuity factor (10%, 5 years)]
= -5 + (2.8 3.791) = 5.6 million

b. If variable cost = 1.20, then total costs increase to:

(1.20 6 million) + 2 million = 9.2 million
Profit before tax per annum = 12m - 9.2m - 1 m = 1.8m
Profit after tax = 60% x 1.8m = 1.08 million
After tax cash flow = 1.08m + 1 m = 2.08m
NPV = -5 million + [2.08 million x 3.791] = 2.9 million

c. If fixed costs = 1.5 million, total costs fall to:

(1 6 million) + 1.5 million = 7.5 million
Profit before tax per annum = 12m - 7.5m - 1 m = 3.5m
Profit after tax = 60% x 3.5m = 2.1 m
Cash flow = 2.1m + 1m = 3.1m
NPV = -5 million + [3.1 million x 3.791] = 6.8 million

d. Call P the price per jar. Then:

Revenue = P 6 million
Expense = ( 1 x 6 million) + 2 million = 8 million
Given depreciation is tax deductible, these results in a tax saving of 1m x 40%
= 0.4m
Therefore, cash flow after tax per annum can be expressed as follows:
Cash flow = [(60% x (6P 8)] + (0.4) = 3.6P 4.4
NPV = -5 + [(3.6P 4.4) x annuity factor (10%, 5 years)]
= -5 + [(3.6P 4.4) x 3.791] = -21.680 + 13.648P
Therefore, NPV = 0 when P = 1.59 per jar

Page -16
PROBLEM 3:

Diamond Ltd

Diamond Ltd has 1m to invest and have identified the following four projects:

Project Investment Outlay Net Present Value

A 400,000 +100,000
B 600,000 +125,000
C 300,000 +90,000
D 250,000 +40,000

Required

Assuming each project is infinitely divisible and the projects are not mutually exclusive,
in which projects should Diamond Ltd invest?

SOLUTION 3:

Diamond Ltd

Rank projects on basis of NPV per of investment required

Project Investment Outlay Net Present Value NPV per Ranking

A 400,000 +100,000 0,25 2

B 600,000 +125,000 0.208 3
C 300,000 +90,000 0.3 1
D 250,000 +40,000 0.16 4

Allocate available funds accordingly

Project Funds used NPV

C 300,000 90,000
A 400,000 100,000
B 300,000 (balance) 62,500 (= 125,000)
1,000,000 252,500

Page -17
 G ROUP 5 E XERCISES

Problem 1: (QUIZ)

Consider the following data for the returns on shares of the swimming pool owned by Splash
plc and that of the Ice Cream Manufacturing Company (ICMC):

Event probability Splash share return ICMC share

Hot weather 0.2 5 30
Modestly warm 0.6 15 15
Cold weather 0.2 20 2
1.0

Required:

a. What is the expected return of each of the two shares?

b. What is the standard deviation of the returns of each of the two shares?

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

portfolios.

Portfolio Proportion of funds Proportion of

invested in ICMC funds invested
A 0.80 0.20
B 0.50 0.50
C 0.25 0.75

d. Draw a risk-return 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 portfolio of
Splash and ICMC shares is 0.62, which gives an expected return of 14.5%).

(QUIZ)

SOLUTION 1:

a.
R i (%) R s (%) p i or p s Ri P i Rsps
30 5 0.2' 6.0 1.0
15 15 0.6 9.0 9.0
2 20 0.2 0.4 4.0

Page -18
 Expected E(R i )= E(R S ) = 14.0%
return 15.4%

b.
(R i - E(R i ))2 p i (R s - E(R S ))2p s
42.63 16.2
0.10 0.6
35.91 7.2
2 = 78.64 = 24.0
= 8.87% = 4.9%

c.
[R i - E(R i )] [Rs - E(R S )] p i
-26.28
-0.24
-16.08
-42.60

Portfolio A:
Expected return: 0.8 15.4 + 0.2 14 = 15.12%
Standard deviation:
(0.82 78.64 + 0.22 x 24 + 2 x 0.8 x 0.2 -42.6)I/2 = 6.1%

Portfolio B:
Expected return: 0.5 15.4 + 0.5 14 = 14.7%

Standard deviation:
(0.52 78.64 + 0.52 x 24 + 2 x 0.5 0.5 -42.6) =2.1%

Portfolio C:
Expected return: 0.25 15.4 + 0.75 14 = 14.35%

Standard deviation:
(0.252 78.64 + 0.752 24 + 2 0.25 0.75 -42.60) =1.56%

Page -19
d.

Page -20
 G ROUP 6 E XERCISES

PROBLEM 1:

Delaware plc

Extracts from Delaware plc's most recent balance sheet are as follows:

000
12% Irredeemable Debentures 4,000

Ordinary Share Capital (1 shares) 8,000

Share Premium Account 2,000
Reserves 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 interest has recently been paid on the debentures. The ordinary shares
are currently quoted at 2.75 and the debentures at 80 per cent (i.e. 80 per 100 nominal
value).

The rate of corporation tax is 30%.

Required

Calculate Delaware's Weighted Average Cost of Capital.

SOLUTION 1:

Delaware plc
Dividend in 1 year's time
Cost of equity = +g
P0

20p 1.1
= + 0.1
275p

= 18%
Interest (1 - tax rate)
Cost of irredeemable debt =
Market value

12 (1 - 0.3)
=
80

= 10.5%

Page -21
 WACC:

Market Value Cost of Capital Weighted Cost

%
Equity 22m 87% 18 15.7
Debt 3.2m 13% 10.5 1.3
25.2m WACC = 17.0%

PROBLEM 2:

Herbert plc

You have been called in as a consultant for Herbert plc, a sporting goods retail firm,
which is examining its debt policy. The firm is currently has a balance sheet as flows;

All amounts in m

Long term bonds 100 Fixed assets 500

Equity 500 Current assets 100
Total 600 Total 600

The firm's income statement is given as follows (all in m):

Revenues 250
Cost of goods sold 175
Depreciation 25
EBIT 50
Long term interest 10
Earning before tax 40
Taxes 16
Net Income 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
return on government treasury bonds is 7% and the market risk premium is 5.5%.

a. What is the firm's current cost of equity?

b. What is the firm's current cost of debt? (You may assume the rate of
corporation tax is 40%).

c. What is the firm's current weighted average cost of capital?

d. Assume that management of Herbert plc is considering doing a debt-equity

swap (i.e., borrowing enough money to buy back 70m shares of stock at 5 per
share). It is believed that this swap will lower the firm's rating to C and raise

Page -22
 the interest rate on the company's debt to 15% and the beta of equity is
expected to increase to 2.8.

What is the firm's new weighted average cost of capital?

SOLUTION 2:

Herbert plc

a. Current cost of equity = 7%+1.12(5.5%)= 13.16%

b. Current pre-tax cost of debt = Interest Expenses/Market value of debt= 10/100

= 10%

The after tax cost of debt = 10% (1 - 0.4) = 6%.

c. The firms current cost of capital (WACC) = D/V r debt (1 - T) + E/V r equity
Where r debt is the pre-tax cost of debt and r debt (1 - T) is the after-tax cost of debt.
Thus WACC = 13.16% (500/600) + 6% (100/600) = 11.97%.

d. If the firm borrows 350 million and buys back shares

New debt = 450m
New equity = 150m
The cost of new equity = 7% + 2.80 (5.5%) = 22.40%
The after tax cost of debt = 15% (1 - 0.4) = 9%
WACC = 22.40% (150/600) + 9% (450/600) = 12.35%

Page -23
PROBLEM 3:

West Ltd

West Ltd is an unquoted company. The recently appointed Finance Director has asked for
your assistance in obtaining a cost of capital that West Ltd can use to appraise its long-
term investment opportunities.

You have been provided with the following information:

2 million 25p ordinary shares valued at 87p

The annual dividend of 180,000, which represents 70% of the amount that was available
for distribution, has just been paid. The company expects to achieve a rate of return of
26% on its retained profits.

1 million 9% preference shares of l0p valued at 80,000 cum div.

lm 8% irredeemable debentures. Debenture holders require a rate of return of 10%.

The rate of corporation tax is 30%.

Required

Calculate for West Ltd its

(a) cost of equity

(b) cost of preference shares

(c) market value of debentures

(d) cost of debentures

(e) weighted average cost of capital

Page -24
SOLUTION 3:

West Ltd

(a) Cost of equity

g = rate of return on equity x plowback ratio

= 26%30% =7.8%

Dividend in 1 year's time

Cost of equity = +g
P0

180 1.078
= + 0.078
1470

= 19.0%

(b) Cost of preference share = Dividends

Market value (e div)
9% 0.10 1m
=
80,000 - (9% 0.10 1m)

9,000
=
(80,000 - 9,000)

= 12.7%

(c) Market value of debentures = Interest

Debenture holders' required rate of return
80
=
0.1
= 0.8m,

(d) Cost of debentures = 10% (1 - tax rate) = 10% (1 - 0.3)

= 7%

(e) WACC:

Market Value % Cost of Capital Weighted

% Cost
Equity 1.740m 66.67c 19 12.7
Pref shares 0.07 lm 2.7% 12.7 0.4
Debt 0.80m 30.6% 7 2.1
2.611m WACC = 15.2%

Page -25
 G ROUP 7 E XERCISES

PROBLEM 1: (NOT INCLUDED IN OUR SYLLABUS)

A Ltd wishes to buy B Ltd for lm. The current balance sheet positions of both companies
are as follows:

A Ltd B Ltd
000 000
Fixed Assets
Factory 450 -
Machinery 250 400
700 400
750 600
1,450 1,000

Net Current Assets

Financed By
Share Capital 150 100
Reserves 1,300 900
1,450 1,000

A Ltd makes pre-tax 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 is estimated that the
combined companies will produce a cash flow of 250,000 for the service of debt, besides
providing the owner with a salary and dividends.

Requirement

Recommend an appropriate financing package.

SOLUTION 1:

A LTD BUYS B LTD

1 m is only the balance sheet value of B Ltd. It is possible that A Ltd may need to
pay more than this to acquire B Ltd's shares!
Would be interesting to know whether there is any surplus cash is in the balance
sheet of A Ltd, and whether the working capital of A Ltd can be 'squeezed' (eg
through better stock and debtors management) to make funds available for
financing this acquisition

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 The owner of A Ltd should only really consider using his own funds and re-
mortgaging his own property after he has exhausted all opportunities for raising
finance via the company
A Ltd currently has no gearing, has 700,000 of fixed assets to offer as security
on debt, and has cash flows of 250,000 per annum to service the debt. The
company therefore has the ability to raise a significant amount of debt.
Assuming lm required, then a possible finance mix could be 250k of cash
(ideally from working capital or alternatively from the owner of A Ltd's own
funds plus re-mortgage of house), then 750k of debt secured on assets of A Ltd
and B Ltd combined

PROBLEM 2:

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
reckon that it could produce profit of 100,000 a year if head office charges were removed;
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

Recommend an appropriate financing package.

SOLUTION 2:

MBO
Management Buy Out's (MBO's) generally involve a substantial amount of cash
injection from the managers to show commitment and obtain ownership
May need to raise more than 400,000 to help finance the future growth
There is a gap between what the managers can raise (100,000) and the minimum
amount required (400,000)
Managers may be reluctant to bring in new equity as this will dilute their control of the
new company
The freehold factory may provide security for senior debt. The company should be
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 company will generate sufficient cash flows to
service the debt interest

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 The managers may look to Venture Capital finance to help fill the financing gap and
strengthen the management team.
Assuming 400,000 will be sufficient initially, suggestion is for the managers to input
100,000, VC's to input 50,000 in exchange for a place on the board, and for senior
debt of 250.000

PROBLEM 3:

A medium-sized company wants to expand, but is held back by high gearing. The planned
expansion is forecast to raise pre-tax profit from 600,000 to 900,000, but initial tooling
costs for the increased manufacturing capacity will amount to 800,000. Bank overdraft
facilities of 1,400,000 are currently fully used. The current position is as follows:

000 000

Fixed Assets 3000

Current Assets 4,200

Creditors: amounts falling due within 1 year

Trade Creditors 1,800
Overdraft 1,400
3,200

Net Current Assets 1,000

4,000
Term Loan 1,600
2,400
Financed By
Share Capital 400
Reserves 2,000
2,400

Requirement

Recommend an appropriate financing package.

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SOLUTION 3:

EXPANSION

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

reached its limits
Gearing including overdraft is already high - unlikely to be able to raise more senior
debt. Junior debt might be possible but interest rate would be expensive.
Unlikely to be much security left to offer for the new finance required
Can the company's working capital be 'squeezed' (e.g. through better stock and
debtors management) to make funds available for financing the expansion?
Raising new equity via rights issue might be a possibility depending upon whether
current shareholders are willing and able to invest further. The current shareholders
might be reluctant for finance to come from new shareholders (e.g. from Venture
Capital) as this will reduce their control of the company
Suggestion - the company might seek to restructure its debt to convert the overdraft
into a longer-term loan. The company might also consider a sale and leaseback of its
property.

PROBLEM 4:

Rights Issue (he discussed, but cannot remember whether it was in the exam or not)

RI plc has 100 million shares in issue. It wishes to raise 25m via rights issue. Its shares
are currently trading at a price of 120p in the stock market.

RI has decided to raise the 25m by issuing 25m additional shares at a subscription price
of 1 per share.

Fred currently owns lm shares in RI plc and has lm of cash in the bank.

Requirement
(a) Calculate the theoretical ex-rights share price.

(b) Show the effect on Fred's wealth if he decides to:

i. Do nothing
ii. Take up the rights
iii. Sell the rights

(c) What effect, if any, does the level of price discount decision have on the wealth of
shareholders? (For example, would it make any difference if 50m shares were
sold at a subscription price of 50p?).
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SOLUTION 4:

RIGHTS ISSUE

(a) Given 25m shares to be issued relative to the 100m shares already in issue, this means
this will be a 1 for 4 rights issue.

Theoretical ex-rights price = MV before rights + cash raised

No. of shares after the rights

= (1.20x 100m) + 25
125m

= 1.16

This assumes the new funds raised by the company will be invested at zero Net Present Value.

(b) Effect on Fred's wealth if:

(i) Does nothing

Before After
Shares (lm1.2) 1.2m (lm1.16) 1.16m
Cash 1.0m Cash 1.00m
2.2m 2.16m

Fred would therefore be 40,000 worse off.

(ii) Takes up rights

Before After
Shares (lm1.2) 1.2m (l.25m1.16) 1.45m
Cash 1.0m Cash (1-0.25) 0.75m
2.2m 2.20m

There would therefore be no effect on Fred's wealth.

(iii) Sell the rights

Before After
Shares (lm1.2) 1.2m (lm1.16) 1.16m
Cash 1.0m Cash (1+(0.2516p*) 1.04m
2.2m 2.20m

There would therefore be no effect on Fred's wealth.

Page -30
*Value of the rights = Ex-rights price - subscription price = 1.16- 1.00 = 16p per share

(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 by re-working
(b) above for a 50m share issue at a subscription price of 50p).

The price discount is only relevant where there is concern that after the rights issue is
announced but before it takes place, the share price might fall beneath the subscription
price. In such circumstances, the rights issue would fail as no-one would take up the rights
offer

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 G ROUP 8 E XERCISES

PROBLEM 1:

MSP LTD

MSP is a private limited company with intentions of obtaining a stock market listing in the
near future. The company is wholly equity financed at present but the directors are
considering a new capital structure prior to it becoming a listed company.

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 estimated to be similar to that of the industry as a whole. The
current level of earnings before interest and tax is 400,000. This earnings level is expected
to be maintained for the foreseeable future.

The rate of return on risk less assets is at present 10% and the return on the market portfolio
is 15%. These rates are post-tax and are expected to remain constant for the foreseeable future.

MSP is considering introducing debt into its capital structure by one of the following methods:

(1) 500,000 10% debentures at par, secured on the company's land and buildings
(2) 1,000,000 12% unsecured loan stock at par

The rate of corporation tax is expected to remain at 33% and interest on debt is tax
deductible.

Required

(a) Calculate for each of the two options:

(i) values of equity and the total market value of the firm
(ii) debt/equity ratios
(iii) the cost of equity

(b) List the main problems and costs which might arise for a company experiencing a
period of severe financial difficulties.

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SOLUTION 1:
(a)

We will use V g = V u + DT

Firstly, calculate the ungeared value of the business, V u

Estimated cash flow after tax (to perpetuity) = 400,000 x (1-0.33) = 268,000

Discount rate using CAPM = 10% + 1.2 (15% - 10%) = 16%

V u = 268,000/0.16 = 1,675,000

500,000 debenture

(i) Vg = 1,675,000 + 500,000x0.33 = 1,840,000 , therefore equity value is

1,840,000 - 500,000 = 1,340,000
(ii) Gearing = 500,000/1,340,000 = 0.37
(iii) Ke = d/P0
Dividend = (400,000 - 50,000) x 0.67 = 234,500
Therefore ke = 234,500/1,340,000 = 17.5%

1,000,000 debenture

(i) Vg = 1,675,000 + 1,000,000x0.33 = 2,005,000, therefore equity value is

2,005,000- 1,000,000= 1,005,000
(ii) Gearing = 1,000,000/1,005,000 = 0.99
(iii) Ke = d/PO
Dividend = (400,000 - 120,000)0.67 = 187,600
Therefore ke = 187,600/1,005,000 = 18.7%

Answers to part (b) are well covered in the textbook and lecture notes.

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PROBLEM 2:

Capital Structure

"Capital structure can have no influence on the value of the firm'.

Discuss this statement and comment briefly on the practical factors which a company might
take into account when determining its capital structure.

PROBLEM 3:

Dividend Policy

'Dividend policy can have no influence on the value of the firm'.

Discuss this statement and comment briefly on the practical factors which a company might
take into account when determining its dividend policy.

SOLUTION 2 & 3:

Answers to problem 2 and 3 are well covered in the textbook and lecture notes.

Page -34