Aaban Technologies Ltd.

is considering a major expansion program that has been proposed by the company’s
information technology group. Before proceeding with the expansion, the company must estimate its cost
of capital.

Assume that you are an assistant to the Chief Financial Officer. Your first task is to estimate Aaban’s cost of
capital. CFO has provided you with the following data, which he believes may be relevant to your task:

 The firm’s tax rate is 40%

 The current price of Aaban’s 12% coupon, semiannual payment, non-callable bonds with 15 years
remaining to maturity is Tk.1,153.72

Aaban does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately
placed with no flotation cost.

 The current price of the firm’s 10%, Tk.100 par value, quarterly dividend, perpetual preferred stock is
Tk.111.10.
 Aaban’s common stock is currently selling for 50 taka per share. Its last dividend (Do) was Tk.4.19 and
dividends are expected to grow at a constant rate of 5% in the foreseeable future. Aaban’s beta is 1.2,
the yield on T-bonds is 7%, and the market risk premium is estimated to be 6%. For the bond-yield-plus-
risk premium approach, the firm uses a risk premium of 4%.
 Aaban’s target capital structure is 30% debt, 10% preferred stock and 60% common equity.

To structure the task somewhat, CFO has asked you to answer the following questions.

(i) What sources of capital should be included when you estimate Aaban’s WACC? Should the
component costs be figured on a before-tax or an after-tax basis? Should the costs be historical
(embedded) costs or new (marginal) costs?
(ii) What is the market interest rate on Aaban’s debt and its component cost of debt?
(iii) Why is there a cost associated with retained earnings? What is Aaban’s estimated cost of common
equity using the CAPM approach?
(iv) What is the estimated cost of common equity using the DCF approach?
(v) What is the bond-yield-plus-risk-premium estimate for Aaban’s cost of common equity?
(vi) What is your final estimate for re (cost of retained earnings)?
(vii) Aaban estimates that if it issues new common stock, the flotation cost will be 15%. Aaban
incorporates the flotation costs into the DCF approach. What is the estimated cost of newly issued
common stock, considering the flotation cost?
(viii) What is Aaban’s overall or weighted average cost of capital (WACC)? Ignore flotation cost? What
factors influence Aaban composite WACC? Should the company use the composite WACC as the
hurdle rate for each of its projects?
Solution

WACC should normally include all sources of long-term funding since it is typically used to make long term
capital investment decisions. Short term capital sources may be included if the intent is to fund asset
purchase. It has often been observed that bank overdraft are more permanent than long term sources.

The component cost should always be on an after-tax basis since any cost that is allowable for tax purposes
reduces tax burden thereby reducing the net cost of debt. It is an incorrect approach to use marginal costs
since the cost will vary with each project giving incorrect feasibility of project from one funding source to
another.
WACC should always be done on the long-term proportions on which future funds are to be raised. This is
often estimated from the past proportions in which funds were raised. The approach should be adopted
unless there is good evidence that the future mix will change.

(ii) Aaban’s 12% bond with 15 year to maturity is currently selling at Tk 1,153.72. Thus, its YTM
(approximate) is

(coupon payment + (Face Value – Market Value)

No of years to maturity C+[(Face Value-Market Value)/
______________________ No of year of Maturity]
Face Value + Market Value YTM =------------------------
2 (Face Value-Market Value)/2

(120+(1000 – 1153.72)/15/(1000 + 1153.72)/2

10.2%
After tax cost 10.2%(1-0.4) = 6.12%

(iii) Cost of Preferred Stock

Annual coupon payment: 10 x 1.025^4 = 10 x 1.10 = 11.04
Cost = Coupon
Market Value
11.04 / 111.10 = 9.9%

(iv) Cost of equity

Using CAPM : 7% + 1.2x6% = 14%
Using Dividend Growth Model
4.19 x 1.05/50 + 0.05 = 13.8%

(v) The bond yield plus risk premium is 14%. The risk premium is calculated by subtracting the risk-free
rate from the expected market return which is the historical returns based on the stock index. It therefore
follows that the figure is an approximation.

(vi) Since the ke under CAPM is 14% and under DGM is 13.8%, an approximate figure of 14% can be used

(vii) D1 / Po (1-F) + g
4.19 x 1.05/ 50 (1-0.15) + 0.05 = 15.35%

(viii) Cost of Capital: 0.30 x 6.12% + 0.10 x 9.9% + 0.60 x 14% = 11.23%
You work as Financial Controller at Padma Paper Ltd. (PPL), a listed Bangladeshi paper manufacturer which
has a financial year end of 30 June.
PPL currently has a very healthy level of liquid funds (approximately BDT 85 m) in its bank accounts. At the
company’s most recent board meeting the following issues were discussed:
- should the firm’s current weighted average cost of capital (WACC) figure of 9% be amended? This figure
has been used for many years and the directors are concerned that this rate does not represent current
market conditions.
- should the dividend growth model or the capital asset pricing (CAPM) model be used to calculate the
WACC?
- should PPL’s long-term funding be restructured?
Cost of capital: The figures below have been given to you for the year ended at 30 June 2018:

Type of capital Total nominal Total dividends /interest Total market value (BDT)
(nominal value) value (BDT) (BDT)

Ordinary shares (10 Tk. per 102,960,000 1,320,000,000

share) 300,000,000
Preference shares (10 Tk. per 3,132,000 54,000,000
share) 20,000,000
Irredeemable debentures 4,050,000 140,175,000
(Tk. 100 each) 130,500,000

Note 1: All dividends have been paid for the year ended 30 June 2018. Ordinary dividends have been
growing at a steady rate of 5% p.a. for the past five years.
Note 2: All debenture interest payable for the year to 30 June 2018 has been paid.
Restructuring the long-term funding
It is decided to purchase and cancel all of PPL’s irredeemable debentures at their current market value.
Issue 8% coupon debentures with a nominal value of BDT 90 million, redeemable in four years’ time at par.
Assume that the corporation tax rate will be 25% pa for the foreseeable future.
Requirements:
(a) Using the dividend growth model, calculate PPL’s current WACC on 30 June 2018.
(b) Giving reasons, advise PPL’s directors whether they should use the WACC figure from part (a) when
appraising potential investments rather than the current figure of 9%.
(c) Discuss the logic underpinning the CAPM and explain how the CAPM can be used to calculate the
WACC.
(d) If, at their issue date, the market gross redemption yield for similar redeemable debentures is 9% pa,
calculate the issue price of the new redeemable debentures and the total funds raised.

(a)

102,960,000 𝑋 1.05
Cost of equity (ke) + 5% = 13.19%
1,320,000,000

3,132,000
Cost of preference shares (kp) = 5.80%
54,000,000

4,050,000 𝑋 (1− .25)

Cost of irredeemable debentures (kd) = 2.17%
140,175,000

Calculation of WACC:

Component Market Value Weight Cost WACC

Cost of Equity 1,320,000,000 87.18% 13.19% 11.50%
Cost of preference shares 54,000,000 3.57% 5.80% 0.21%
Cost of irredeemable debentures 140,175,000 9.26% 2.17% 0.20%
11.91%
So, based on the figures given, PPL’s WACC figure is approximately 11.91%.
(b)

PPL’s WACC (11.86%) is higher than the 9.0% figure currently used and this should be used as a hurdle rate
in investment appraisal. Otherwise PPL could be taking on projects that have an IRR of more than 9%, but
less than 11.91%. To do so would mean that PPL’s shareholders’ wealth would decline as these projects
would produce negative NPV’s.

The weighting shown above is based on the current capital structure. PPL should review whether the above
capital structure would remain in the long term. If changes are foreseen, the long-term capital structure
should be used to work out the WACC instead of the current structure. The fact that the company does not
have any debt but is awash with excess cash shows that the company is missing out on investment
opportunities to leverage its capital structure and bring higher return to its shareholders.

(c)
The Capital Asset Pricing Model (CAPM) is an alternative method of calculating the cost of equity. As such it
can be used within the WACC calculation.

The CAPM assumes that investors are diversified, i.e. they have diversified specific risk away. Thus, it takes
account of systematic risk only and measures the systematic risk of investments. This risk is measured as an
index (beta). The beta index of a security is applied to the risk premium of the market portfolio (equity
shares). The risk premium is the rate of return from the market portfolio less rate of return from risk-free
securities. Thus, with the CAPM, a higher beta (systematic risk) index will mean a higher cost of equity.

Viewed in a different perspective, the beta represents the riskiness of the security. A beta lower than
indicates that the security is less risky whereas a beta higher than 1 indicates a risky security that will bring
in high volatility in shareholders earnings.

(d)

Selling price of redeemable debentures

Year Cash Flow (BDT) PV Factor @ 9% PV (BDT)

1-4 Interest 7,200,000 3.240 23,328,000
4 Redemption 90,000,000 0.708 63,720,000
PV of future cash flows @ 87,048,000
9%
Total funds raised = BDT 87.05 Million
Heat Wave Limited (HWL) manufactures and fits large scale heating units for factories and warehouses.
Key information about the company’s equity capital at 31 July 2018 is shown below:

Issued ordinary shares (BDT 1 nominal value) 55 million

Market value per ordinary share (ex div) BDT 2.20
Price earnings ratio 8.4
Dividend payout ratio 40%
Profit after tax as % of Capital Employed 10%
Equity beta 1.3
Risk free rate 7%
Market rate of return 11%

At 31 July 2018 HWL also had in issue BDT 10 million 9% convertible loan stock with a market value of
BDT 105 (ex-interest), which is redeemable at BDT 104 on 31 July 2022 or it could be converted to 40
ordinary shares at that date. You should assume that the market value of HWL’s ordinary shares will
increase at the same annual growth rate as its ordinary dividends.
Th
e rate of corporation tax is 28% and is payable in the same year as profits are earned.

On 6 August 2018 HWL’s board met with representatives of Quality Household Ltd. (QHL), a large
retailer of household goods. QHL wishes to expand its product line via a new range of small domestic
heaters and would like HWL to manufacture and supply them. HWL would have to purchase new
equipment to manufacture the heaters and this would cost BDT 18 million. HWL’s board is proposing
to raise the BDT 18 million via an issue of 10% debentures (redeemable in July 2026). Alternatively, it
could raise the majority of the BDT 18 million via a one for ten rights issue of ordinary shares at a 15%
discount on the current market price per ordinary share. The balance would come from retained
earnings. However, Ahmed Chowdhury, one of HWL’s directors, is concerned that a rights issue could
be unsuccessful and the company could lose money as a result.

Requirements:
(a) Calculate HWL’s weighted average cost of capital at 31 July 2018 using the Gordon growth (or
earnings retention) model to calculate the cost of equity.
(b) Calculate the cost of equity using the CAPM and explain the reasoning behind the CAPM approach
to the cost of equity, comparing the CAPM approach with the earnings retention model used in part
(a).
(c) Explain the benefits to a company of using convertible loan stock as a means of raising capital
(d) Assuming that the funds are raised by the debenture issue, discuss whether HWL should use the
cost of the newly issued debentures as the hurdle rate when appraising the Value Shopper investment.
(e) Discuss Ahmed Chowdhury’s concerns.
Solution
3. (a)
Cost of equity - Gordon growth (earnings retention) model
P/E = 8.4 or 2.2/E = 8.4. Hence E = 2.2/8.4
Current dividend per ordinary share = BDT 2.20/8.4 x 40% = BDT 0.1047
Dividend growth (b x r) = 10% x (1-0.4) = 6%
Cost of equity (Ke) = {(10.47 x 1.06) / 220} + 6% = 11%

Cost of convertible loan stock (CLS)

Value of shares at conversion (@ 31 July 2022) = BDT 2.20 x (1.06)4 = BDT 2.78/share
Conversion of BDT 100 of loan stock = 40 shares
Total value of shares (40 x BDT 2.78) = BDT 111.20
 Year Cash Flow 5% Factor PV 10% Factor PV
0 -105 1 -105 1 -105
4-Jan 9 3.546 31.914 3.17 28.53
4 111.2 0.823 91.5176 0.683 75.9496
Net Present Value 18.4316 -0.5204

IRR = 5+ 18.4316 x 5 9.9

18.952
Cost of CLS (net of tax) (9.9 *0.72) 7.1

WACC
Market
Weighted
Cost Value Weighting
Cost
(BDT)
Equity 11.00% 121 121.0/131.5 10.12
CLS 7.10% 10.5 10.5/131.5 0.57
131.5 WACC 10.69

(b)

ke = 7% + 1.3 (11% - 7%) = 12.2%

The Capital Asset Pricing Model (CAPM) is used in project appraisal and it shows that the discount rate should
be related to the project’s risk. As risk increases so will the returns required by investors. CAPM distinguishes
between specific and systematic risk and it assumes that investors will have diversified away specific risk. It
is therefore based on systematic risk and a project’s/share’s relationship to the market average (measured
by beta). Beta is also a measure of the covariance of the market and equity return divided by the market
return.

The earnings retention model is an alternative method of calculating the discount rate and is based on the
idea that the current price of a share is the present value of future dividends and capital growth. Dividend
growth occurs by retaining and reinvesting profits on which a return is earned.

The costs are different and would only be expected to be the same in a perfect world.

(c)

Convertible loan stock is fixed return securities which can, at the option of the holder, be converted into
ordinary shares of the same company. Its benefits are:

- The issuing company can obtain finance at lower rates of interest.

- It encourages investors with the prospect of a future share in profits.
- It introduces an element of gearing, albeit short-term.
- It can avoid redemption problems (cash flow).
- It means that equity can be issued cheaply (via conversion).
- It does not dilute shareholder control initially.
- Suitable to finance projects with long pay-back periods

(d)
HWL’s current market value is BDT 131.5m [see part (a)] and so the additional BDT 18m being raised is small
(immaterial) in comparison (13.7%). Thus, the existing WACC should be used as it’s reasonable to assume
that the firm’s balance of equity and debt will be maintained in the long term.

The operating risk of the QHL proposal is considerable – it’s a new product and a new market. Thus the
existing WACC may not be relevant and CAPM should be considered as a means of establishing the hurdle
rate. Alternatively, APV could be used. The cost of the new debt represents the risk to the lenders and not
that of the project.

(e)

By doing nothing a shareholder would lose money and so must take up the rights or sell his/her rights. So,
HWL’s shareholders may react negatively to the rights issue, especially if there have been previous calls for
extra capital via this method. As a result, HWL’s share price could decrease.

Many of the issue costs will be fixed and have been estimated at 4% on BDT 2 million raised, so a rights issue
is fairly expensive.

HWL should consider underwriting the rights issue as a means of insurance against the issue being
unpopular. Whilst this is an expensive option, it is preferable to HWL failing to raise sufficient funds and
being unable to proceed with its planned investment.

Fizzers Ltd is a Bangladeshi Company which makes a range of soft drinks, over 90% of which are sold in
Bangladesh market. The company currently has a cash surplus, and the directors are contemplating a
major investment in a plant in the Middle East to supply the local market. The Middle East market,
important for the company, is currently supplied from Bangladesh.
To assess the economic viability of the investment, the finance department needs a rate at which to
discount the projected cash flows from the plant. It has been decided to use the company’s weighted
average cost of capital (WACC) deducing the cost of equity through the dividend growth model.
The company’s most recent balance sheet, dated 31 August 20X9 included the following capital and
reserves section.
CU’000
Called up share capital (ordinary shares of CU 0.10 each fully paid) 5,750
Retained earnings 29,750

The company also had in issue CU100 million of 9% loan stock. This to be redeemed on 1 September 20Y0
at par. Interest is payable (in arrears) on 1 September each year. It has been the company’s practice to pay
a single dividend each year during September.
Dividends paid per share over recent year’s have been as follows:
Pence
20X4 21.25
20X5 22.50
20X6 22.50
20X7 24.50
20X8 25.00
The 20x9 dividend will be 25.50 pence per share. The company’s issued and fully paid share capital has not
altered since 20X3.
At 31 August 20x9 the shares were quoted at CU 3.35 per share (cum-div) and the loan stock at CU 101.72
(cum-interest) per CU 100 nominal.
The corporation tax rate is expected to remain at 21% for the foreseeable future.
Requirement
(a) Determine the company’s weighted average cost of capital, explaining your workings and
justifying any assumptions which you have made
(b) Explain why the figure which you have determined in (a) may not be totally reliable for the
purpose for which it has been determined
(c) As an alternative to investing in the Middle Eastern plant the directors are considering a
takeover bid for Zoom Ltd anther soft drinks manufacturer.
Set out the advantages and disadvantages of the following three types of bid
I. Cash
II. Share for share exchange
III. Loan stock for share exchange

Solution
Cost of equity (ke)
Assuming the dividend growth over he last five years is a good indicator of shareholder’s expectations
regarding the future:
g= 25.5 1/5 - 1 = 3.71%
21.25
Using Gordon growth model, ke = D0(1+g) + g
P0
25.5 1.0371 + 0.0371 = 12.25%
335 – 25.5
MV of shares = 57,500 x100 x 3.095 = CU 177,962,500
Cost of debt (kd)
It will be the IRR of the cash flows from the company’s perspective
Time Cash Flow DF PV
0 92.72 1.000 92.72
1 (109.00) 0.851(bal) (92.72)

0.851 is given by 1/(1 + i) hence 1/(1+i) = 0.851

0.851i + 0.851 = 1 or i = 17.51%
Post tax cost of debt 17.51 (1- 0.21) = 13.83%
The MV of debt = CU 100 million 92.72% = CU 92,720,000 (ex interest)

WACC
The WACC normally includes long-term finance only. In the case of Fizzers Ltd the debt is to be redeemed
in one year’s time. Thus, the debt should only be included in the WACC if it is assumed that more debt will
be raised in the near future to replace it. If not, then the WACC is the cost of equity of 12.25%.
WACC = (12.25 x177.96 +13.83 x 92.72) = 12.79%
270.68
The assumptions made above are justifiable for the following reasons:

 Past dividend growth has been reasonably steady, so it likely that shareholders will expect similar in
the future. It is their expectations that determine the share price. Growth of 2% in 20X8 and 20x9
might be a better estimate for future growth than the five-year average

 The company’s existing gearing ratio (debt: equity) is approximately 1:2 which seems reasonable.
Because debt has some advantages e.g. low cost of issue, tax relief on interest, no dilution of
earnings per share (compared to say rights issue) some gearing is advised, so is likely that the
directors will seek to raise more debt in the future. Whether they will aim for exactly the same
gearing ratio and use debt with the same cost is less certain.
(b) Suitability
The WACC has been calculated to use a discount rate for appraising the new overseas venture. To use
the existing WACC relies on the following assumptions

 Gearing is kept constant

 The project has the same business risk as the company’s existing activities.
 The project is small
The figure calculated is not suitable for the following reasons.

 It is implied that the project will be financed out of retained cash reserves. This will not preserve
the current gearing of the company
 The overseas venture involves a different market with different systematic risk to the bulk of
existing activities
 The project is a major undertaking and hence carries a bigger business risk
 CAPM is a better measure compared to Gordons cost of equity.

© Three types of bid

Advantages Disadvantage
Cash  Fizzers has plenty of cash  Depending on the value of Zoom,
 There will be no dilution of more cash may have to be found
control in Fizzers  Zoom shareholders lose their
 Zoom shareholders receive a interest in the business
certain sum
Shares  Fizzers liquidity is preserved.  Issue costs of new shares
Cash surplus can be used  Dilution of control for Fizzers
elsewhere existing shareholders
 Zoom shareholders keep an
interest in the enlarged firm
Loan Stock  No dilution of control for Fizzers  Obligation to pay interest
shareholders  Increased gearing for Fizzers
 Fixed income return may appeal
to Zoom shareholders
Bradford Bedwyn Medical plc (BBM)
BBM is a UK company that manufactures a range of medical equipment for use in hospitals and doctors’
surgeries. BBM has a year end of 28 February and it has been trading since 1993
Extracts from BBMs most recent management accounts are shown below

Income Statement for the year ended 28 February 20x4 £ 000s

Profit before interest and taxation 6,816
Debenture interest (516)
Profit before taxation 6,300
Taxation (21%) (1,323)
Profit after taxation 4,977
Dividends (1,493)
Retained profits 3,484

Balance Sheet at 28 February 20X4

Ordinary Share Capital (£ 1 shares) 34,600
Retained earnings 31,384
65,984
6% Redeemable Debentures (Redeemable 20x9) 8,600
74,584
BBMs ordinary shares had a market value of £ 2.45 each (ex-div) and a beta of 0.9 on 28 February 20x4.
The return on the market is expected to be 8.6% and the risk-free rate is 2.1% pa.
BBMs debentures had a market value of £ 110 (cum interest) per £ 100 nominal on 28 February 20x4 and
they are redeemable at par on 28 February 20x9
BBMs board is now considering diversifying its operations by expanding into a new market. The average
equity beta for companies already operating in this market is 1.9 with an average ratio of equity to debt
(by market values) of 83.17
This diversification will cost BBM approximately £ 25 million. However, there is disagreement amongst
BBMs directors as to how the diversification should be funded and whether it should happen at all. There
are three proposals that are being considered.
Proposal 1
BBM proceeds with the diversification. It would raise the additional funding required from equity and debt
sources in such a way as to leave its existing equity: debt ratio (by market values) unchanged following the
diversification. The additional debt raised would be in the form of 8% redeemable debentures issued at par
Proposal 2
BBM proceeds with the diversification. It would raise all of the additional funding required in the form of
8% redeemable debentures issued at par.
Proposal 3
BBM does not proceed with the diversification. The funds, raised as in proposal 2 are used instead to buy
back some of its ordinary shares.
Assume that the corporation tax rate will be 21% pa for the foreseeable future.
Requirements
 1. Ignoring the diversification plans, calculate BBMs WACC (weighted average cost of capital) on 28
February 20x4 using
a. The Gordon’s Growth Model
b. The CAPM
2. Explain the limitations of Gordon’s growth model
3. Assuming that Proposal 1 is accepted and using the CAPM, calculate the WACC that BBM should use
when appraising its diversification plans and explain your reasoning
4. Assuming that Proposal 2 is accepted, discuss the issues that BBM faces when trying to determine
an appropriate WACC when appraising its diversification plans
5. Assuming that Proposal 3 is accepted, explain why BBM would wish to buy back its shares and they
implications for its shareholders.

Solution:
Cost of equity

Dividend/share for year to £ 1,493/34,600 £ 0.0432

28/2x4
Dividend growth rate g =rb r = current accounting rate of return
b =proportion of profits retained
Current accounting rate of Earnings/Opening Equity Capital R = 8%
return Employed
(£ 4,977/ (£65,984 – £3,484)
Proportion of profit retained Retained Profit/ Earnings B= 70%
£ 3,484/£ 4,977

Thus, the growth rate (g) = 8% x 70% = 5.6%

Ke = d1 + g = 0.0432 x 1.056 + 0.056 = 7.5%
P 2.45
Kd

Year Cash Flow 5% PV 10% PV

0 (104.00) 1.000 `(104.00) 1.000 (104.00)
1-5 6 4.329 25.97 3.791 22.75
5 100 0.784 78.40 0.621 62.10
0.37 (19.15)

This IRR is approximately 5% so kd is 5% (1 – 0.21) = 3.95%

WACC Market
Value
Equity 34,600 x £ 2.45 84,770 7.5% x 84,770/93,714 6.78%
6% debentures £ 8,600 x 8,944 3.95% x 8,944/93,714 0.38%
104/100
93,714 WACC 7.16%
b)
Market risk premium (8.6% - 2.1%) 6.5%
BBM’s beta is equity beta so no adjustment required 0.9
BBMs risk premium (6.5% x 0.9) 5.85%
Plus: risk free rate 2.10%
Cost of equity via CAPM 7.95%

WACC
Market
value
Equity 84,770 7.95% x 84,770/93,714 7.19%
6% debentures 8,944 3.95% x 8,944 / 93,714 0.38%
93,714 WACC 7.57%

2.
Gordon’s growth model is a simple model of dividend behavior. In particular
The growth rate (g) must be less than the cost of equity (ke). Otherwise the share price will be infinitely
high. To maintain such a high growth rate to perpetuity is impossible. Companies are likely to experience
periods of varying growth for which sophisticated models have been developed.
In addition, the model:
 Relies on accounting profits
 Assumes that b and r are constant
 Can be distorted by inflation
 Assumes all new finances is from equity or gearing is held constant

3.
Asset Beta(Unlevered) = Equity beta
[1 + (1-tax rate)(total debt/equity)]

Equity Beta(Levered) = Asset Beta x [1 + (1-tax rate)(total debt/equity)]

Equity Beta of the new market 1.90

Asset beta of the new market 1.9 / [1+ (0.79x17/83) 1.63
BBM’s equity beta for the new market 1.63 x [1+(0.79x8,944/84,770) 1.77
(We are assuming that BBM’s asset beta is the same as Market Asset Beta)
BBMs cost of equity
BBMs risk premium (6.5% x 1.77) 11.51%
Plus: risk free rate 2.10%
Cost of equity via CAPM 13.61%
Cost of new debt (8% x 79%) 6.32%

WACC
Market
value
Equity 84,770 13.61% x 84,770/93,714 13.31%
6% debentures 8,944 6.32% x 8,944 / 93,714 0.60%
93,714 WACC 12.91%

BBMs current WACC figure is 7.16% ~ 7.57% depending on the method of calculation. It would be unwise
to use this figure (approximately 7%) when appraising the diversification.
This is because the company will be working in a new market and its systematic risk (a key tenet of the
CAPM) will change. This new market has a beta of 1.9 whereas BBM currently uses a beta of 0.9.
Were BBM to under estimate its WACC figure, it would overestimate the NPV of the planned
diversification. The cost of new debt is higher.
4.
Gearing and systematic business risk have both changed. To get WACC one needs the MV of equity which
includes the NPV of the project. To get NPV one needs WACC. So, it is a circular argument. One could use
APV to overcome this.
BBM cannot use the cost of the new debt after tax as the required return of the shareholders would be
ignored. Neither can it use its risk adjusted cost of equity (as this ignores debt finance raised)
It can’t use the risk adjusted WACC figure from 3 above because BBMs gearing level will have changed (it is
an all-debt issue) – the WACC to be used then depends on the reaction to the increased gearing. If
however there was a subsequent issue of equity planned which would re-establish the current gearing
level, then the risk adjusted WACC from 3 could be used.
5.
Normally, a share buy-back returns money to shareholders and enables a company to use surplus cash
when there are no investment opportunities with a positive NPV available. It doesn’t appear to be the case
here as the company is issuing debt.
If BBM made a large dividend payment this would be contrary to company dividend policy. It might have an
adverse effect on the company’s share price – uncertainty created if larger dividend is not maintained in
future.
A buy back would reduce the number of shares in the market and this will mean that BBM’s earnings per
share and market value per share may increase depending on the reaction to the change in gearing – see
below.
A buy back could change control e.g. remove the influence of an unwelcome shareholder by buying their
shares.
A share buy back would increase BBM’s gearing, which might, if BBM is below its optimal level of gearing,
lead to an increase in BBM’s share price via a reduced WACC. If however BBM is higher than its optimal
level of gearing, the cost of debt and consequently the cost of equity may go up leading to a change in
WACC.
A buy back gives a capital gain rather than a dividend subject to income tax

Seager Forest Scientific plc

SFS is a large listed pharmaceutical company with a financial year end of 30 Aril. Its management accounts
on 30 April 20x1 are expected to show the following:
£m
Issued ordinary share capital (50p shares) 300.00
Retained earnings 118.90
Shareholders’ funds 418.98
Redeemable debentures (redeemable at par in 20x4) 120.00
9% Irredeemable debentures 80.00
618.98
Extract from SFS Income Statement for the year to 30 April 20x1
£m
Profit before interest and taxation 84.10
Less debenture interest (15.60)
Profit before taxation 18.50
Less taxation (21%) (14.39)
Profit after taxation 54.11
Less dividends 12.00
Retained profit 42.11

Ignoring any effect of the new funds and investment discussed below, the prices of SFS equity and debt on
30 April 20x1 are expected to be:
Ordinary shares £1.24 each, ex-div
7% Redeemable debentures (20x4) £96.00 each, ex-int
9% Redeemable debentures (20x4) £94.00 each, ex-int

SFS has not increased its issued share capital since 20W8. Its dividend per share for the year to 30 April
20x0 was 3.7% of the 50p par value and the dividend growth rate anticipated for the year to 30 April 20x1
is expected to continue in the foreseeable future.
New funds and investment
SFS’s board is discussing how to raise £ 110 million on 1 May 20x1 and unsure whether this should be via
an issue of equity or debt. This additional funding will enable SFS to expand its product range and establish
a foothold in new geographical markets and according to the board’s estimates, next year’s profit before
interest figure (to 30 April 20x2) will increase by 8% over the previous year.
Equity issue – it is planned to raise the £ 110 million by a 1 for 6 rights issue. However, one of the directors
is concerned that this will have an adverse effect on the company’s earnings per share figure and has
suggested that a “higher multiple (i.e. 1 for 8 or even 1 for 10) would be better
Debt issue- alternatively the £ 110 million would be raised by an issue of 6% irredeemable debentures at
par
SFS’s directors would like to assume that he corporation tax rate will be 21% for the foreseeable future.
Requirements
1. Calculate average cost of capital
2. The individual cost of whichever new source of funding (ie equity or debt) is selected would be a
suitable hurdle rate to appraise the planned new investment.
3. Calculate SFS’s earnings per share figure for the year to 30 April 20x2 for the new funding the board
chooses
a. A 1 for 6 rights issue
b. An issue of 6% irredeemable debentures
4. Comment on the directors’ assertion that, regarding the rights issue, “a higher multiple (ie 1 for 8 or
even 1 for 10 would be better.”

Solution
Dividend % in 20x0/1 = £ 12m/300 4%
Dividend % in 20W9/x0 3.7% x 50p 1.85p
Dividend/share 20x0/x1 £ 12m/600 2p
Dividend growth rate 4%/3.7% (or 2/1.85) = 1.081 8.1%
Cost of equity d1 + g = (£0.02 x 1.081) + 8.1% 9.84%
MV £ 1.24

Cost of redeemable debt

Year Cash Flow 5% PV 10% PV

0 (96.00) 1.000 `(96.00) 1.000 (96.00)
1-3 7 2.723 19.06 2.487 17.41
3 100 0.864 86.40 0.751 75.10
9.46 (3.49)

IRR = 5% + [5% x (9.46/(9.46 + 3.49))] = 8.65%

Post tax = 8.65 x (1 – 0.21) = 6.83%
Cost of irredeemable debt = [9% x (1-0.21)]/£ 94 = 7.56%
£m
Total market value of equity =600m x £ 1.24 = 744.000
Total market value of redeemable debt = 120m x 96/100 115.200
Total market value of irredeemable debt= £ 80m x 94/100 75.200
Total market value 934.400
WACC
Weighted average cost of equity 9.84% x £744.000/£ 934.400 7.83%
Weighted average cost of redeemable debt 6.83% x £115.200/£ 934.400 0.84%
Weighted average cost of irredeemable debt 7.56% x £75.200/£ 934.400 0.61%
9.28%

SFS’s long term funding has a current market value of £ 934.400 million. It plans to raise an additional £
110 million which represents an 1.5% increase on the current market value. This is a relatively small
increase and so it is reasonable to use the existing WACC as the hurdle rate.
However, SFS will be using the new funding to expand its product range and its foothold in new
geographical market. This may mean that the level of risk changes and a different hurdle rate should be
used to appraise the investment. CAPM should be considered as a means of establishing the hurdle rate.
3
SFS Income Statement for the year to 30 April 20x2
Existing Issue Debt Issue
£ £
Profit before interest and taxation (£84.1m x 1.08) 90.828 90.828
Less debenture interest (W1) (15.600) (22.200)
Profit before taxation 75.228 68.628
Less taxation @ 21% (15.798) (14.412)
Profit after taxation 59.430 54.216
Earnings per share (EPS) £59.430/700m 8.49p
£54.216/600m 9.04

Working £m
Interest cost of existing debt [(7% x £ 120m) + 9% x £80m)] 15.6
Interest cost of new debt (6% x £110m) 6.6
23.2
4.
The current EPS (20x0/x1) 54.110m/600m 9.02p
EPS after 1 for 6 rights issue (59.430m/700m) 8.49p
EPS after 1 for 8 rights issue (59.430m/675m) 8.80p
EPS after 1 for 10 rights issue (59.430m/560m) 9.00p

EPS will be lower in all three cases above. A 1 for 10 issue (ie fewest extra shares in issue) would give the
best EPS result for the three
However, a 1 for 10 rights issue (60m extra shares) would mean that the issue price would have to be
£1.83/share (£110m/60m). As the current market value is only £1.24/share then the rights issue would not
be successful.
Similarly, a 1 for 8 rights issue (75m extra shares) would mean that the issue price would have to be
£1.47/share (£110m/75m). As the current market value is only £1.24/share then the rights issue would not
be successful.
A 1 for 6 rights issue (100m extra shares) would mean that the issue price would be £1.10/share
(£110m/100). This is not a massive discount (11%) on the current market value.
It may be that a smaller multiple (1 for 5) might be needed, even though the impact on the EPS would be
negative.
N Ltd and J Ltd are home product manufacturers that have the same business and operational risk
characteristics.
Financial information relating to each company is as follows:
Nereus Ltd (m) Janus Ltd (m)
CU 0·25 ordinary shares 12·5 CUm 25·0
CUm
Reserves 25·0 60·0
37·5 85·0
6% Loan capital 20·0 –
–––––
57·5 –––––
85·0
Profits before interest charges CU11·0m CU22·0m
Current market prices:
Ordinary shares CU1·63 CU2·05
Loan capital CU90 per CU100 –
nominal

N Ltd has recently had its share and loan capital listed on the London Stock Exchange, and since the listing,
the directors have taken a keen interest in the price movements of these securities. The directors believe that,
for the loan capital, the market price has reached an equilibrium level. However, they do not believe that this
is the case for the ordinary shares. They are concerned that the shares may be undervalued and that this may,
in turn, increase the vulnerability of the company to a hostile takeover bid.

J Ltd is a well-established company and it is generally believed that the market price of the company’s
ordinary shares reflect their equilibrium price. However, the directors of J Ltd consider that ordinary
shareholders might benefit from an increase in the level of the company’s gearing. Consequently, there is
a proposal to issue sufficient 6% irredeemable loan capital for cash to enable the company to purchase
and cancel 40 million ordinary shares.

Assume a rate of corporation tax of 25%.

Required:
(a) Using the assumption of Modigliani and Miller (including taxation):

(i) calculate the equilibrium price of an ordinary share in N Ltd; and

(ii) calculate the effect of the proposed change in capital structure on the market value of an ordinary
share in J Ltd.

(b) Briefly comment on the results in (a) above.

(c) Identify and discuss possible weaknesses in the assumptions underpinning the views of Modigliani and
Miller (including taxation) on valuation and capital structure.

Solution

(i) The relevant MM formula is :

Vg = Vu + Dt
Where:
Vg = value of a geared company

Vu = value of an ungeared Company

Dt = value of the tax shield on debt
The market value of J Ltd is: 100m x
CU2·05 = CU205m
As profit (before interest) of J Ltd is double that of N Ltd, the value of N Ltd should be:
Vu = CU205m/2
= CU102·5m
As the corporation tax rate is 25%
Dt = [CU20m x 90/100] x 25%
= CU4·5m
Vg = CU102·5m + CU4·5m
= CU107·0m

As the value of the loan capital is CU18m [CU20m x 90/100], the value of the ordinary shares in N
Ltd is: CU107·0m less CU18·0m = CU89·0m
The equilibrium price of an ordinary share of N is, therefore: CU89·0/50m= CU1·78

(ii) The amount of debt raised would be 40m x CU2·05 = CU82m

The market value of J Ltd is currently CU205m. The value of the company following the issue of debt but
before cancellation of ordinary shares would be:

Vg = V u + D t

Vg = CU205m + (25% x CU82m) Vg= CU225·5m

The market value of an ordinary share in J Ltd following the proposed change in capital structure is,
therefore:
= (CU225·5m - CU82m)/(100m - 40m) = CU143·5m/60m = CU2·39

(b) On the basis of the calculations shown in (a)(i) above, the shares in N Ltd appear to be undervalued
and so the concerns of the directors of the company may have some substance. However, the calculations
are based on the assumption that the two companies have identical business and operational risk
characteristics. In practice, this would be a rare occurrence and the difference between the current market
price of N Ltd and the figure calculated above may be due to differences in risk characteristics.
The calculations in (a)(ii) show that the remaining shareholders of J Ltd would benefit from the tax shield
effect of loan capital and would see an increase in their share price by more than 16%, assuming the
benefits of repurchase are in proportion to their holdings.

(c) Possible weaknesses in the assumptions of Modigliani and Miller (MM) that remain after taxation
has been taken into account, include the following:
Bankruptcy costs: High levels of borrowing may place a business at risk of being unable to meet its
contractual obligations to pay interest and to make capital repayments when they fall due. This can, in
turn, lead to bankruptcy, which can be very costly for both lenders and shareholders. MM assumed that
it would be possible to issue loan capital at high levels of gearing, but the fear of bankruptcy among
lenders and shareholders may make this impossible in practice.
Interest rates: MM assumed that interest rates demanded by lenders would remain constant even at high
levels of gearing. However, at very high levels of gearing, lenders will be providing most of the capital of
the business and will consequently be taking on most of the risk. They will expect to be compensated for
this by receiving higher returns.
Shareholder behavior: MM assume that equity shareholders will be unconcerned by increases in gearing
as they can adjust their portfolio of investments to take account of changes in the financial risk of one
particular business. However, many investors do not hold a well-diversified portfolio of investments and
so, in practice, changes in the risk characteristics of a particular business may concern them.
ABC Ltd is an unlevered firm with expected annual earnings before taxes of Tk 21mn in perpetuity. The
current required return on the firm’s equity is 16%, and the firm distributes all of its earnings as
dividends at the end of each year. The company has 1.3 million shares of common stock outstanding
and is subject to a corporate tax rate of 35%. The firm is planning a recapitalization under which it will
issue Tk 30mn of perpetual 9% debt and use the proceeds to buy back shares.

(a) Calculate the value of the company before the recapitalization plan is announced. What is the
value of equity before the announcement? What is the price per share?
(b) Use the Adjusted Present Value (APV) method to calculate the company value after the
recapitalization plan is announced. What is the value of equity after the announcement? What is the
price per share?

(c) How many shares will be repurchased? What is the value of equity after the repurchase has been
completed? What is the price per share?

Solution

(a) The company is currently an all-equity firm, so the value as an all equity firm equals the present value
of after-tax cash flows, discounted at the cost of the firm’s unlevered cost of equity. So, the current
value of the company is:

Vu = (Pretax earnings)(1-T))/r
Vu = ((Tk 21,000,000)(1-.35))/0.16 = Tk 85,312,500

The price per share is the total value of the company divided by the shares outstanding, or:

Price per share = Tk 85,312,500/1,300,000

Price per share = Tk 65.63

(b) The adjusted present value of a firm equals its value under all equity financing plus the net present value
of the tax shield. In this case, the NPV of financing side effects equals the after-tax present value of cash
flows resulting from the firm’s debt. Given a known level of debt, debt cash flows can be discounted at
the pretax cost of debt, so the NPV of the financing effects are:

NPV of tax shield

Tax shield = Tk 30,000,000 x 0.09 x 0.35 = Tk 945,000
NPV = Tk 945,000 / .09 = Tk 10,500,000

So the value of the company after the recapitalization using the APV approach is:
V = Tk 85,312,500+10,500,000
V= Tk 95,812,500

Since the company has not yet issued the debt, this is also the value of equity after the announcement.
So, the new price per share will be:
New share price = Tk 95,812,500/1,300,000 = Tk 73.70
(c) The company will use the entire proceeds to repurchase equity. Using the shares we calculated in part
(b), the number of shares repurchased will be:
Shares repurchased = Tk 30,000,000/Tk 73.70 = Tk 407,045

And the new number of shares outstanding will be:

New shares outstanding = 1,300,000 – 407,045 = 892,955.

The value of the company increased, but part of that increase will be funded by the new debt. The value
of equity after recapitalization is the total value of the company minus the value of debt, or:

New value of equity = Tk 95,812,500-30,000,000 = Tk 65,812,500

So, the price per share of the company after recapitalization will be:
New share price = Tk 65,812,500/892,955
New share price = Tk 73.70

The price per share is unchanged.

 Assume you have just been hired as business manager of Subway Pizza Limited, a pizza restaurant located
adjacent to the commercial hub of Dhaka. The company's EBIT was Tk.500,000 last year, and since the
area is restricted, EBIT is expected to remain constant (in real terms) over time. Since no expansion
capital will be required, Subway Pizza Limited plans to pay out all earnings as dividends. The management
group owns about 50 percent of the stock, and the stock is traded in the stock exchanges.

The company is currently financed with all equity; it has 100,000 shares outstanding; and current market
price P0= Tk.25 per share. When you apply your knowledge of finance, you believe that most company
owners would be financially better off if the company used some debt. When you suggested this to your
new boss, he encouraged you to pursue the idea. As a first step, assume that you obtained from the
firm's investment banker the following estimated costs of debt for the firm at different capital structures:

Financed With Debt (%) Cost of Debt %

0 ---
20 8.0
30 8.5
40 10.0
50 12.0

If the company were to recapitalize, debt would be issued, and the funds received would be used to
repurchase stock. Subway Pizza Limited is in the 40 percent corporate tax bracket, its beta is 1.0, the risk-
free rate is 6 percent, and the market risk premium is 6 percent.

Requirements:
(a) Provide a brief overview of capital structure effects. Be sure to identify the ways in which capital
structure can affect the weighted average cost of capital and free cash flows.

(b) What is business risk? What factors influence a firm's business risk? What is operating leverage, and
how does it affect a firm's business risk? Show the operating breakeven point if a company has fixed
costs of Tk.200, a sales price of Tk.15, and variable costs of Tk.10.

(c) Now, to develop an example which can be presented to Subway Pizza Limited’s management to
illustrate the effects of financial leverage, consider two hypothetical firms: firm U, which uses no debt
financing, and firm L, which uses Tk.10,000 of 12% debt. Both firms have Tk.20,000 in assets, a 40 percent
tax rate, and an expected EBIT of Tk.3,000.

(i) Construct partial income statements, which start with EBIT, for the two firms. Then, calculate ROE
for both firms. What does this example illustrate about the impact of financial leverage on ROE?
(ii) Explain the difference between financial risk and business risk. Now consider the fact that EBIT is
not known with certainty, but rather has the following probability distribution:

Economic State Probability EBIT

Bad 0.25 Tk.2,000
Average 0.50 Tk.3,000
Good 0.25 Tk.4,000
 Finally, calculate the standard deviation and coefficient of variation of ROE. What does this example
illustrate about the impact of debt financing on risk and return?

(d) What does capital structure theory attempt to do? What lessons can be learned from capital structure
theory? Be sure to address the Modigliani–Miller (MM) models. With the above points in mind, now
consider the optimal capital structure for Subway Pizza Limited.

(e) For each capital structure under consideration, calculate the levered/geared beta, the cost of equity,
and the WACC. Then, calculate the corporate value, the value of the debt that will be issued, and the
resulting market value of equity.

Solution

(a) The basic definitions are:

(1) V = Value 0f Firm

(2) FCF = Free Cash Flow
(3) WACC = Weighted Average Cost of Capital
(4) Ke and Kd are costs of stock and debt
(5) We and Wd are percentages of the firm that are financed with stock and debt.

The impact of capital structure on value depends upon the effect of debt on: WACC and/or Free Cash
Flow (FCF). Debt holders have a prior claim on cash flows relative to stockholders. Debt holders’ “fixed”
claim increases risk of stockholders’ “residual” claim, so the cost of stock, rs, goes up.

Firms can deduct interest expenses. This reduces the taxes paid, frees up more cash for payments to
investors, and reduces after-tax cost of debt

Debt increases the risk of bankruptcy, causing pre-tax cost of debt, Kd, to increase.

Adding debt increase the percent of firm financed with low-cost debt (Wd) and decreases the percent
financed with high-cost equity (We).

The net effect on WACC is uncertain, since some of these effects tend to increase WACC and some tend
to decrease WACC.

Additional debt can affect FCF. The additional debt increases the probability of bankruptcy. The direct
costs of financial distress are legal fees, “fire” sales, etc. The indirect costs are lost customers, reductions
in productivity of managers and line workers, reductions in credit (i.e., accounts payable) offered by
suppliers. Indirect costs cause NOPAT to go down due to lost customers and drop in productivity and
causes the investment in capital to go up due to increases in net operating working capital (accounts
payable goes up as suppliers tighten credit).

Additional debt can affect the behavior of managers. It can cause reductions in agency costs, because
debt “pre-commits,” or “bonds,” free cash flow for use in making interest payments. Thus, managers
are less likely to waste FCF on perquisites or non-value adding acquisitions.

But it can cause increases in other agency costs. Debt can make managers too risk-averse, causing
“underinvestment” in risky but positive NPV projects.
 There are also affects due to asymmetric information and signaling. Managers know the firm’s future
prospects better than investors. Thus, managers would not issue additional equity if they thought the
current stock price was less than the true value of the stock (given their inside information). Hence,
investors often perceive an additional issuance of stock as a negative signal, and the stock price falls.

(b) Business risk is uncertainty about EBIT. Factors that influence business risk include: uncertainty about
demand (unit sales); uncertainty about output prices; uncertainty about input costs; product and other
types of liability; degree of operating leverage (DOL).

Operating leverage is the change in EBIT caused by a change in quantity sold. The higher the proportion
of fixed costs within a firm’s overall cost structure, the greater the operating leverage. Higher operating
leverage leads to more business risk, because a small sales decline causes a larger EBIT decline.
Operating leverage is mainly impacted by high fixed costs.

Q is quantity sold, F is fixed cost, V is variable cost, TC is total cost, and P is price per unit.

Operating Breakeven = QBE

QBE= F / (P–V)
Example: F = Tk.200, P = Tk.15,and V = Tk.10:
QBE=Tk.200 / (Tk.15 – Tk.10) = 40.

(c) (i) Here are the fully completed statements: FirmU FirmL
Assets Tk.20,000 Tk.20,000
Equity Tk.20,000 Tk.10,000
EBIT Tk.3,000 Tk.3,000
Interest (12%) 0 1,200
EBT Tk.3,000 Tk.1,800
Taxes (40%) 1,200 720
NI Tk.1,800 Tk.1,080

FirmU FirmL
ROA 15.0% 15.0%
ROE
AAA 9.0% 10.8%
A
Conclusions from the analysis:
• The firm’s return on assets, ROA = EBIT/total assets, is unaffected by financial leverage.
• Firm L has the higher expected ROE:

o ROEU = 9.0%.
o ROEL = 10.8%.

Therefore, the use of financial leverage has increased the expected profitability to shareholders. The
higher ROE results in part from the tax savings and also because the stock is riskier if the firm uses
debt.

• At the expected level of EBIT, ROEL > ROEU.

(ii) Business risk increases the uncertainty in future EBIT. It depends on business factors such as
competition, operating leverage, etc. Financial risk is the additional business risk concentrated on
common stockholders when financial leverage is used. It depends on the amount of debt and
preferred stock financing.
 Here are the proforma income statements:

Bad Avg. Good Bad Avg. Good

Prob. 0.25 0.50 0.25 0.25 0.50 0.25
EBIT Tk.2,00 Tk.3,00 Tk.4,000 Tk.2,00 Tk.3,00 Tk.4,000
Interest 0
0 0
0 0 1,2000 1,2000 1,200
EBT Tk.2,00 Tk.3,00 Tk.4,000 Tk.800 Tk.1,80 Tk.2,800
Taxes (40%) 0
800 1,2000 1,600 320 7200 1,120
NI Tk.1,20 Tk.1,80 Tk.2,400 Tk.480 Tk.1,08 Tk.1,680
ROA 10.0%0 15.0%0 20.0% 10.0% 15.0%0 20.0%
ROE
EA 6.0% 9.0% 12.0% 4.8% 10.8% 16.8%

Value x = (xi -
Firm U Prob Mean xp
(xi) µ)2
Bad 6 0.25 1.5 9 2.3
Average 9 0.5 4.5 0 0
Good 12 0.25 3 9 2.3
(µ) 9 4.5
Standard
√ variance 2.12
Deviation
Coefficient of Variation 2.12 0.24
9

x = (xi -
Firm L Value Prob Mean xp
µ)2
Bad 4.8 0.25 1.2 36 9
Average 10.8 0.5 5.4 0 0
Good 16.8 0.25 4.2 36 9
(µ) 10.8 18
Standard
√ variance 4.24
Deviation
Coefficient of Variation 4.24 0.39
10.8

This example illustrates that financial leverage can increase the expected return to stockholders. But, at
the same time, it increases their risk.

• Firm L has a wider range of ROEs and a higher standard deviation of ROE, indicating that its higher
expected return is accompanied by higher risk. To be precise:

σ ROE(Unlevered)= 2.12%, and(Levered)= 4.24%.

σ Coefficient of variation(Unlevered)= 0.24, and (Levered)= 0.39

Mean ROE of Firm U is 9.0 whereas the mean ROE of Firm L is marginally higher at 10.8 but carries a
higher business risk.
 Modigliani-Miller (MM) theory begins with the assumption of zero taxes. Modigliani-Miller
(MM)prove, under a very restrictive set of assumptions, that a firm’s value is unaffected by its
financing mix:

VL (Value of Levered firm) = VU (Value of Unlevered firm).

Therefore, capital structure is irrelevant. Any increase in ROE resulting from financial leverage is exactly
offset by the increase in risk (i.e., rs), so WACC is constant.

MM theory later includes corporate taxes. Corporate tax laws favor debt financing over equity financing.
With corporate taxes, the benefits of financial leverage exceed the risks because more EBIT goes to
investors and less to taxes when leverage is used. MM shows that:

VL (value of the leveraged firm) = VU (value of the unleveraged firm) + TD (tax shield provided by debt).

If T=40%, then every Taka of debt adds 40 paisa of extra value to firm.

Miller later included personal taxes. Personal taxes lessen the advantage of corporate debt.

Corporate taxes favor debt financing since corporations can deduct interest expenses, but personal taxes
favor equity financing, since no gain is reported until stock is sold, and long-term gains are taxed at a
lower rate. Miller’s conclusions with personal taxes are that the use of debt financing remains
advantageous, but benefits are less than under only corporate taxes. Firms should still use 100% debt.
Note: however, miller argued that in equilibrium, the tax rates of marginal investors would adjust until
there was no advantage to debt.

Modigliani-Miller (MM) theory ignores bankruptcy (financial distress) costs, which increase as more
leverage is used. At low leverage levels, tax benefits outweigh bankruptcy costs. At high levels,
bankruptcy costs outweigh tax benefits. An optimal capital structure exists that balances these costs and
benefits. This is the trade-off theory.

Modigliani-Miller (MM) assumed that investors and managers have the same information. But managers
often have better information. Thus, they would sell stock if stock is overvalued, and sell bonds if stock
is undervalued. Investors understand this, so view new stock sales as a negative signal. This is signaling
theory.

One agency problem is that managers can use corporate funds for non-value maximizing purposes. The
use of financial leverage binds “free cash flow” and forces discipline on managers to avoid perks and
non-value adding acquisitions.

A second agency problem is the potential for “underinvestment”. Debt increases risk of financial distress.
Therefore, managers may avoid risky projects even if they have positive NPVs.

(e) Modigliani-Miller (MM) theory implies that beta changes with leverage. Bu(unlevered beta) is the beta
of a firm when it has no debt (the unlevered beta.). Hamada’s equation provides the beta of a levered
firm: BL (levered/geared beta) = BU[1+(1- T)(D/S)].

For example, to find the cost of equity for wd=20%, we first use Hamada’s equation to find beta:

BL =BU[1 + (1 -T)(D/S)]
= 1.0[1 + (1-0.4) (20%/80%)]
 = 1.15

Then use Capital Asset Pricing Model (CAPM) to find the cost of equity:

RS (Cost of Equity) =RRF+BL(RPM) =6%+1.15(6%)=12.9% where, RPM is Risk Premium

We can repeat this for the capital structures under consideration.

WD D/S BL RS
0% 0.00 1.000 12.00%
20% 0.25 1.150 12.90%
30% 0.43 1.257 13.54%
40% 0.67 1.400 14.40%
50% 1.00 1.600 15.60%

Next, find the WACC.

For example, the WACC for wd (weightage of debt) =20%is:

WACC=wd(1-T) rd+ wers

WACC=0.2 (1– 0.4) (8%)+0.8(12.9%)
WACC=11.28%

Then repeat this for all capital structures under consideration.

wd (weightage of debt) rd (cost of debt) rs (cost of WACC
equity)
0% 0.0% 12.00% 12.00%
20% 8.0% 12.90% 11.28%
30% 8.5% 13.54% 11.01%
40% 10.0% 14.40% 11.04%
50% 12.0% 15.60% 11.40%

The corporate value for

Wd = 20%is: V= FCF/ (WACC-G)

G=0,

So, investment in capital is zero;

So,FCF=NOPAT=EBIT(1-T).

In this example, NOPAT = (Tk.500,000) (1 - 0.40) = Tk.300,000.

Using these values, V=Tk.300,000 / 0.1128 = Tk.2,659,574.

Repeating this for all capital structures gives the following table:
wd (weightage of debt) WACC Corp. Value
0% 12.00% Tk.2,500,000
20% 11.28% Tk.2,659,574
30% 11.01% Tk.2,724,796
 40% 11.04% Tk.2,717,391
50% 11.40% Tk.2,631,579

As this shows, value is maximized at a capital structure with 30% debt.

Current EPS of Dhaka Lamps Ltd. is Tk. 20, the assets beta is 0.90, the retention rate is 0.50, the tax rate is
0.35, the annual growth rate is 8.085%, the debt-equity ratio is 0.12, the risk-free rate is 5 per cent and the
equity market risk premium is 6 per cent. What is the impact on the price of the share if the debt-equity ratio
increases to 0.30.

Solution

Using the capital asset pricing model:

Ke = rf + b x Risk premium
= 0.05 + 0.90 x 0.06
= 10.4%

Using Gordon Growth Model:

Dividend: 0.5 x 20 = Tk 10
Growth: 8.085%
Ke = 10.4%

Price = 10 x 1.08085
0.104 – 0.08085
= 10.8085
0.02315
= 466.89

If Debt to Equity increases to 0.30

Be = Ba[1 + (1 -t)(D/E)]
= 0.90 [1 + (1 – 0.35)0.30]
= 0.90 [1 + 0.195]
= 1.0755
Ke = rf + b x Risk premium
= 0.05 + 1.0755 x 0.06
= 11.453%

Price = 10 x 1.08085
= 0.11453 – 0.08085
= 10.8085
0.03368
= 320.92

After financial reconstruction, the price drops by 31%

The following financial information refers to NN Ltd.:
Current statement of financial position

Tk.m Tk.m Tk.m

Assets
Non-current assets 101
Current assets
Inventory 11
Trade receivables 21
Cash 10
42
Total assets 143
Equity and liabilities
Ordinary share capital 50
Preference share capital 25
Retained earnings 19
Total equity 94
Non-current liabilities:
Long-term borrowings 20
Current liabilities
Trade payables 22
Other payables 7
Total current liabilities 29
Total liabilities 49
Total equity and liabilities 143

NN Ltd. has just paid a dividend of 66 paisa per share and has a cost of equity of 12%. The dividends of the
company have grown in recent years by an average rate of 3% per year. The ordinary shares of the company
have a par value of 50 paisa per share and an ex dividend market value of Tk. 8·30 per share.
The long-term borrowings of NN Ltd. consist of 7% bonds that are redeemable in six years’ time at their par
value of Tk.100 per bond. The current ex interest market price of the bonds is Tk.103·50.
The preference shares of NN Ltd. have a nominal value of 50 paisa per share and pay an annual dividend of
8%. The ex div market value of the preference shares is 67 paisa per share.
NN Ltd. pays profit tax at an annual rate of 25% per year.
Required:
(a) Calculate the equity value of NN Ltd. using the following business valuation methods:
(i) the dividend growth model;
(ii) net asset value.
(b) Calculate the after-tax cost of debt of NN Ltd.
(c) Calculate the weighted average after-tax cost of capital of NN Ltd.

Solution

(a)(i) Using Growth Model:

Price = 66 x 1.03
0.12 – 0.03
 = 755 p or Tk 7.55

In order to calculate the share price based on Net Asset Value, we have to deduct the Fair Value of all external
liabilities from the Fair Value of Total Assets. The Fair Value of total assets is not known; hence we will use
the historical cost figures.

The MV of External Liabilities are as follows:

MV of Long-Term Borrowings: 200,000 x 103.50 = Tk 20.7 million
MV of Preference Shares: 50,000,000 x 0.67 = Tk 33.5 million

Hence Net Asset Value = 143 – 29 – 20.7 – 33.5 = 59.8 million or Tk 0.60 per share
The current market value of equity is: 100 million x 8.3 = Tk 830 million

(b) After tax cost of debt:

Year Cash Flow 5% PV 10% PV
0 (103.50) 1.000 (103.50) 1.000 (103.50)
1-6 7.00 5.076 35.53 4.355 30.49
6 100.00 0.746 74.60 0.564 56.40
6.63 (16.61)
By interpolation:

Gross Cost of Debt: 5 + 6.63 x 5 = 6.43%

(6.63 + 16.61)

After tax cost of debt: 6.43 (1 – 0.25) = 4.82%

Cost of preference shares:

Preference Dividend: 8% of 50p = 4p
Market Value per share = 67p
Cost = 4/67 % = 5.97%

(c) WACC:
Market
Value (m)
Equity 830.0 12% x 830/884.2 11.26%
Debt 20.7 4.82% x 20.7/884.2 0.11%
Preference shares 33.5 5.97% x 33.5 / 884.2 0.23%
884.2 WACC 11.60%

Price Ltd wishes to acquire the entire share capital of Maine Ltd. Details of current earnings and P/E ratios
are as follows:
Earnings (Cum) P/E
Price Ltd 50 20
Maine Ltd 20 15

It is believed that as a result of synergies, the combined earnings would be CU75m and the market would
apply a P/E of 18 to the combination.
Requirements:
(a) What is the maximum amount Price Ltd should pay for Maine Ltd?
(b) What price are Maine’s shareholders likely to accept.

Solution
CUm
(a) Combined value = CU 75 x 18 = 1,350
Market Price on its own = CU 50 x 20 = (1,000)
Maximum Amount = 350

(b) Current value of Maine Ltd = CU 20 x 15 = 300

This is likely to be the minimum price. Anything between CU 300m and CU 350m splits the
additional 50m between the two sets of shareholders.

The following information is provided relating to the acquiring company Efficient Ltd. and the target
company Health Ltd: Dec 31, 2010:
Efficient Ltd. Health Ltd
No. of shares (F.V. Tk.10 each) 10.00 lakhs 7.5 lakhs
Market Capitalization 500.00 lakhs 750.00 lakhs
P/E ratio (times) 10.00 5.00
Reserves and Surplus 300.00 lakhs 165.00 lakhs
Promoter’s Holding (No. of shares) 4.75 lakhs 5.00 lakhs

Board of Directors of both the companies have decided to give a fair deal to the shareholders and
accordingly for swap ratio the weights are decided as 40%, 25% and 35% respectively for Earnings,
Book Value and Market Price of share of each company.

Required:
i) Calculate the swap ratio and also calculate Promoter’s holding % after acquisition.
ii) What is the EPS of Efficient Ltd. after acquisition of Health Ltd.?
iii) What is the expected market price per share and market capitalization of Efficient Ltd. after
acquisition, assuming P/E ratio of firm Efficient Ltd. remains unchanged?
iv) Calculate free float market capitalization of the merged firm.

Solution

EPS

Efficient Ltd
Market Price = 500 /10 = Tk 50
P/EPS = PE Ratio
50/EPS = 10
EPS = 50/10 = 5

Health Ltd
Market Price = 750 /7.5 = Tk 100
P/EPS = PE Ratio
100/EPS = 5
EPS = 100/5 = 20

Book Value

Efficient Ltd
Share Capital (Tk 10 x 10 lac shares Tk 100 lacs
Reserves and Surplus Tk 300 lacs
Net Assets Tk 400 lacs
No of shares 10 lacs
NAV per share Tk 40

Health Ltd
Share Capital (Tk 10 x 7.5 lac shares Tk 75 lacs
Reserves and Surplus Tk 165 lacs
Net Assets Tk 240 lacs
No of shares 7.5 lacs
NAV per share Tk 32

Weighted Average share value for swap ratio

Criteria Taka in Lacs Weight WAV

Efficient Health Efficient Health
Earnings 5.00 20.00 40% 2.00 8.00
Book value 40.00 32.00 25% 10.00 8.00
Market Price 50.00 100.00 35% 17.50 35.00
29.50 51.00
Swap Ratio = 51.00 / 29.50 = 1.73 (1.73 share of Efficient for every 1 share of Health).

Calculation of Promoter’s holding % after acquisition

Total shareholding after acquisition = 10 lacs + (7.5 lacs x 1.73) = 22.97 lacs

Promoters of Efficient Ltd = 4.75 lacs / 22.97 lacs = 20.68%

Promoters of Health Ltd = (5.00 lacs x 1.73)/22.97 lacs = 37.66%
Total Promoters Share Holding = 58.34%

©(ii) EPS of Efficient Ltd after acquisition:

Total earnings = [5 x 10) + (20 x 7.50] = Tk 200 lacs

No of shares = 22.97 lacs
EPS = 200 / 22.97 = Tk 8.71

©(iii) Expected Market Price after acquisition

PE = MP/EPS
10 = MP/8.71
MP = Tk 87.10tk
Market Capitalization: Tk 87.10 x 22.97 shares = Tk 2000.69 lacs.

©(iv) Free Float after acquisition:

Free Float shares: Total shares – Promoters shares i.e. 22.97 – (4.75 + 8.65) = 9.57 lacs
Free Float after capitalization: 9.57 lac shares x Tk 87.10 = Tk 833.55 lacs
A Company belongs to a risk class for which the appropriate capitalization rate is 10%. It currently has 25,000
outstanding shares selling at Tk.100 each. The firm has been contemplating the declaration of a dividend of
Tk.5 per share at the end of the current financial year. The company is expecting to have net income of
Tk.2,50,000 and has a proposal for making new investment of Tk.5,00,000.

Required:
Prove the assumption that payment of dividend does not affect the value of the firm?

Solution
As per MM hypothesis, dividend policy has no impact in determining the value of the firm as well as
increasing the wealth of the shareholders.

We know that:

Po = D1 + P1
(1 + ke)
P1 = Po (1 + ke) – D1
100(1.10)-5 = Tk 105

The Shareholders Wealth

Share Value 105

Dividend 5
Total Wealth 110

If dividend is not paid, the share value would be 100 (1.10) = 110

Share Value 110

Dividend 0
Total Wealth 110

Hence the wealth of the shareholder remains unchanged irrespective of payment of dividend

CNC has an all common equity capital structure. It has 200,000 shares of Tk 2 par value common stock
outstanding. When CNC’s founder, who was also its research director and most successful inventor, retired
unexpectedly in late 2014, CNC was left suddenly and permanently with materially lower growth
expectations and relatively few attractive new investment opportunities. Unfortunately, there was no way
to replace the founder’s contributions to the firm. Previously, CNC found it necessary to plough back most
of its earnings to finance growth, which averaged 12% per year. Future growth rate at 5% rate is considered
realistic, but the level would call for an increase in the dividend payout. Further, it now appears that new
investment projects with at least 14% rate of return required by CNC’s stockholders would amount to only
Tk 800,000 for 2015 in comparison to a projected Tk 2,000,000 of net income. If the existing 20% dividend
payout were continued, retained earnings would be Tk 1.6mn in 2015, but, as noted, investments that yield
the 14% cost of capital would amount to only Tk 800,000.

The one encouraging point is that the high earnings from existing assets are expected to continue, and net
income of Tk 2mn is still expected for 2015. Given the dramatically changed circumstances, CNC’s
management is reviewing the firm’s dividend policy.
Requirements:
i. Assuming that the acceptable 2015 investment projects would be financed entirely by earnings
retained during the year and that CNC uses the residual dividend model, calculate DPS in 2015.
ii. What payout ratio does your answer to part (i) imply for 2015?
iii. If a 60% payout ratio is maintained for the foreseeable future, what is your estimate of the
present market price of the common stock? How does this compare with the market price that
should have prevailed under the assumptions exiting just before the news about the founder’s
retirement? If the two values of Po are different, comment on why.
iv. What would happen to the price of the stock if the old 20% payout were continued? Assume that
if this payout is maintained, the average rate of return on the retained earnings will fall to 7.5%
and the new growth rate will be 6%.

Solution:

(i) Projected Net Income 2,000,000

Less: projected capital investment 800,000
Available residual 1,200,000
Shares outstanding 200,000
(ii) DPS = Tk 1,200,000 / 200,000 = Tk 6 = D1
EPS = Tk 2,000,000 / 200,000 = Tk 10
Payout ratio = 6/10 = 60%
(iii) Currently Po = D1/ke – g = Tk 2/ (0.14 – 0.12) = Tk 100
If the current payout ratio of 60% continues, with the reduced growth of 5%, the price drops to Tk
6/ (0.14 – 0.05) = Tk 66.67.
The drop-in price is due to the drop-in growth from the earlier figure of 12% to 5%

(iv) With the old payout of 20%, growth would be:

G = br = 0.8 x 0.075 = 0.06 (as given in the problem)
Po = 2 / (0.14 – 0.06) = Tk 25

Assume that you own 100 shares of BTech Ltd, a small software development firm. When you read the Daily
Star Business page this morning, BTech’s shares were selling at Tk 50. There are 10,000 shares outstanding,
with most of them being held by small investors such as yourself. On the way to work, you hear on the radio
that a group of outsider investors have managed to acquire 20% of the firm and are attempting a hostile
takeover. They are offering Tk 75 a share for any and all outstanding shares. The analyst on the radio goes
on to say that, due to the bidder’s expertise at managing similar companies, the equity in the firm is expected
to be worth Tk 1 million of their bid is successful. Assume that there would be no tax effects if you sell your
shares.

Requirements:

(i) Should you sell your shares to the bidder?

(ii) What will happen if everyone makes the same/ sell buy decision you do?
(iii) What does this imply about the bid price of successful takeover attempts?

Solution
(i) You will only sell your shares if you feel that the takeover attempt will fail. If the attempt succeeds, each
share will be worth Tk 100, so you won’t be willing to sell for Tk 75. If it fails, each share will only be worth
the current market price of Tk 50.

(ii) In that case, the above buy/hold decision will apply.

(iii) The underlying reason for the paradox above is that the bid price is lower than the post-takeover value
per share. Normally, successful bid must be set above the expected value per share, so that shareholders
who sell, profit more than shareholders who don’t. That is why, enough shareholders will tender their shares.
In fact, all the shareholders will want to tender their shares, but in order for the bidders to make money on
the deal, they also set a restriction on how many shares they will buy.

Shapla Ltd is contemplating the acquisition of Padma Limited. The values of the two companies as separate
entities are BDT 30 million and BDT 10 million respectively. Shapla estimates that by combining the two
companies, it will reduce marketing and administration costs by BDT 700,000 per year in perpetuity. Shapla
can either pay BDT 15 million cash for Padma Limited or offer Padma a 50% holding in Shapla.

The opportunity cost of capital is 10%.

Required:

I. What is the gain from merger?

II. What is the cost of the cash offer?
III. What is the cost of the stock alternative?
IV. What is the NPV of the acquisition under the cash offer?
V. What is the NPV of the acquisition under the stock offer?

Solution:

I. Gain = 700,000 / 0.10 = BDT 7,000,000

II. Cost of cash offer = cash paid – PV of Padma
15,000,000 – 10,000,000
BDT 5,000,000
Iii Cost of stock offer
0.5(30m + 10m +7m) – 10,000,000
BDT 13,500,000
Iv NPV = Gain – Cost
7,000,000 – 5,000,000
BDT 2,000,000
v. NPV = Gain – Cost
7,000,000 – 13,500,000
BDT (6,500,000)

M Ltd has recently announced a takeover bid for A Ltd. The offer is that for every four A Ltd ordinary shares
the owner would receive three ordinary shares in M Ltd plus CU 6 in cash. Both companies are listed.

According to published estimates, if A Ltd were to remain independent the company would pay its next
dividend in one year’s time at 37p per share. Subsequently, dividends are expected to grow by an average
5% pa. A Ltd has an equity cost of capital of 12%.

Estimates for M Ltd assuming that the takeover goes ahead, suggest that a dividend of 43p per share will be
paid in one year’s time and the same amount in two years’ time. In three years’ time the dividend paid will
be 7% higher than the 43p to be paid next year and the year after. This rate of growth is expected to continue
indefinitely. The expanded M Ltd is expected to have a cost of equity of 11% pa
Required:

(a) Show calculations that indicate whether, on the basis of the published estimates, Angelic Ltd
shareholders would be advised to accept the offer from M Ltd
(b) Discuss reasons why any particular shareholder might look beyond the result of the calculations in (a)
when deciding whether to accept the offer.
(c) Suggest the possible effect on A Ltd’s ordinary share price of the announcement of be bid, stating and
explaining any assumptions made in reaching your conclusion
(d) Suggest and explain any other strategies that M Ltd could use to achieve growth, apart from taking over
other business.

Solution

(a) Evaluation of a takeover offer

Value of A Ltd share (Po) = D1 / (ke –g)

0.37 / (0.12 – 0.05)
5.29
0.43 (1.07)
Value of M Ltd share = 0.43 + 0.43 + 0.11 -0.07
1.11 1.112 1.112
= 10.07
The holder of one share will receive CU6 + (3 x CU 10.07) = CU 9.05
4
Therefore accept the bid

(b) Discussion of the limitations of the calcuations in (a) as the basis of a decision
Possible reasons include the following

 Lack of confidence in the estimates on which the calculations are based

 Unwillingness on the part o A Ltd shareholders ot hold M Ltd shares – dividend policy, level of capital
gearing etc and he cost of share dealing charges to move out of M Ltd shares.
 It looks as if these two companies may have a different risk profile and A Ltd shareholders may not
be happy with this
 The cash payment may not be appealing to A Ltd shareholders because of the potential capital gains
tax charge to which this may give rise.

(c) Suggestions on how a target company’s share price would tend to move when a takeover offer is
announced.

If the market were to accept the estimates and believe that he bid would be successful and disregards the
factors in (b), A Ltd’s share price would tend immediately to move to CU 9.05

If the market were to believe that the bid would be successful, but M Ltd would have to increase its bid to
succeed, the price would tend to rise to more than CU 9.05

If the market were to believe that the bid would be unsuccessful the A Ltd share price would tend to remain
at this present level

Changes in market perceptions during the bid period may cause the share price to move around to reflect
those changes.
(d) Suggestions for strategies for growth without making takeovers

Alternatively, growth could be achieved organically bu undertaking internally-generated projects,

perhaps suing retained earnings to finance them.

Another growth strategy might be to “buy-in” parts of other businesses, perhaps large parts, without
going for a full takeover. Buy-ins tend to involve only the assets, whereas takeovers involve the whole of
the business including the liabilities.