Corporate Finance – BA303

Tutorial 11 (Answers)
Corporate Finance BA303
1. What is this firm’s WACC? (ignore tax)
■ debt-to-equity ratio = 40%
■ cost of equity = 18%
■ cost of debt = 8%
Answer :

2. Calculate the cost of debt facing a firm issued £50 million in debentures in £100 units 2
years ago at a nominal interest rate of 8% per annum in each of the following cases:
i. Market value of debt is £45 million; perpetual life
ii. As for (i), but allowing for Corporation Tax at 30%
iii. As for (i), but lifespan of debt is 8 years
iv. As for (iii), but with tax payable at 30%

Answers:

i. Kd = (0.08 x £100) / (£45 million/(£50 mill/£100)) = 0.0889 = 8.89%

ii. Kdat = 0.089(1-0.3) = 0.0623 = 6.23%
iii. Kd = YTM ≈ [C + ((M-P)/n)]/[(M+P)/2] ≈ [8 + ((100-90)/8)]/[(100+90)/2] ≈0.0974 ≈
9.74%

YTM : Yield-to-Maturity; C: Coupon or Interest Payment; M: Par Value; P:

Market Price; n: No. of years to maturity

iv. Kdat ≈ 0.0974(1-0.3) ≈ 0.0682 ≈ 6.82%

3. Calculate the value of the tax shield in each of the following cases, all based on borrowing
of £100 million at 10% interest per annum, pre-tax.
i. Perpetual life debt, tax rate is 30%
ii. Debt repayable in full after 5 years
iii. Debt repayable in equal tranches over 5 years, interest paid on the declining balance.

Answers :

i. Interest charged = 0.1 x £100 mill = £10 mill; Value of tax shield today = (Amount of
Interest paid x Tax rate) / Interest rate = (£10 mill x 0.3) / 0.1 = £30 million

ii. Value of tax shield today = [(Amount of Interest paid x Tax rate) / (Interest rate)] x
[(1-(1/(1+Interest Rate)n)] ; n: No. of years to maturity

1
 Corporate Finance – BA303

 Value of tax shield today = [(£10 mill x 0.3) / (0.1)]/[(1-(1/(1+0.1)5)] = £11.37

million

iii. Value of tax shield today = [(I1Ʈc)/(1+r)] + [(I2Ʈc)/(1+r)2] + [(I3Ʈc)/(1+r)3] +

[(I4Ʈc)/(1+r)4] + [(I5Ʈc)/(1+r)5] = [(£10 mill x 0.3)/(1+0.1)] + [(£8 mill x 0.3)/(1+0.1)2]
+ [(£6 mill x 0.3)/(1+0.1)3] + [(£4 mill x 0.3)/(1+0.1)4] + [(£2 mill x 0.3)/(1+0.1)5] ≈
£2.73 mill + £1.98 mill + £1.35 mill + £0.82 mill + £0.37 mill ≈ £7.25 million.

Ii : Amount of interest paid at year i

Ʈc : Corporate Tax Rate
r : Interest rate per annum

4. Calculate the WACC for the following company, using both book value and market value
weights.

Balance Sheet Values Cost of Capital

Ordinary Shares: (par £10 mill 20%
value 50 pence per share)
Reserves £20 mill 20%
Long-term debt £15 mill 10%

The debt is permanent and its market value is equal to book value. Corporate tax rate = 30%. The
current market price of the ordinary shares = £4.50/share. Reserves are not invested.

Answer:
Market-Value based:

No. of ordinary shares outstanding = £10 mill / £0.50 = 20 million shares

Market value of ordinary shares = Market price x No. of ordinary shares outstanding =
£4.50 x 20 mill = £90 million
Market value of long-term debt = £15 million
Total market value = £105 million

After-tax WACC = [(90/105)0.2] + [(15/105)0.1(1-0.3)] = 0.1814 = 18.14%

Book-Value based:

Book value of ordinary share = £10 million

Book value of long-term debt = £15 million
Book value of reserves = £20 million
Total book value = £45 million

After-tax WACC =[(10/45)0.2] + [(15/45)0.1(1-0.3)] + [(20/45)0.2] = 0.1567 = 15.67%

2
 Corporate Finance – BA303

5. The directors of Zeus plc are considering opening a new manufacturing facility. The finance
director has provided the following information:

Initial capital investment: £2,500,000

Dividends for the last 5 years have been:

Year 2013 2014 2015 2016 2017

Net dividend 10.0 10.8 11.4 13.2 13.7
per share
(pence)

The following is an extract from the statement of financial position of Zeus plc for the year ended
31st December, 2017.

Creditors due in more than 1 year

8% debenture £700,000
Long-term loan (variable rate) £800,000
Capital and reserves £500,000
2,000,000 shares of 25 pence each

The authorized share capital is 4 million shares, and the current market price per share at 31 st
December, 2017 is 136 pence ex-dividend.

The current market price of debentures is £60(ex-interest) and interest is payable each year on 31st
December.

The interest rate on the long-term loan is 1% above the London Interbank Offer Rate (LIBOR),
which at present stands at 16%.

The debentures are irredeemable.

Ignore taxation.

Required:
Calculate the WACC for Zeus at 31st December, 2017.

Answer:

Capital structure :

Market value of equity = no. of shares x market share price = 2 mill x £1.36 = £2.72 mill

Market value of debenture = £700,000 x £60/£100 = £0.42 mill

3
 Corporate Finance – BA303

Market value of long-term loan = Book value of long-term loan = £0.8 mill
Total market value = £2.72 mill + £0.42 mill + £0.8 mill = £3.94 mill

Weights Cost of Capital

Equity 0.69 0.191
Debenture 0.107 0.133
Long-term loan 0.203 0.17
Total 1

Calculations of Cost of equity:

10.0(1+g)4 = 13.7
g ≈ 0.082
ke = (D1/P0) + g = [13.7(1.082)/136] + 0.082 =0.191 = 19.1%

Cost of debenture = Amount of Interest paid / Market price of debenture = 8% x £100/£60

= 0.133 = 13.3%

Cost of long-term loan = 16% + 1% = 17%

WACC = (0.191 x 0.69) + (0.133 x 0.107) + (0.17 x 0.203) = 0.181 = 18.1%

6. Explain what is meant by ‘cost of capital’. Why is it important for a company to calculate its
cost of capital correctly ?

Answer:
A company’s cost of capital is the discount rate which, when used to discount the future cash
flows of the particular company, will not result in any change in the value of the business.
The cost of capital is crucial in appraising investment opportunities, because it represents
the minimum return required for investors. The net present value (NPV) of an investment
project is calculated by discounting its future cash flows by the cost of capital of the company.
For a company wishing to maximise the wealth of its shareholders, only investment projects
yielding a positive NPV should be accepted. If the cost of capital is calculated incorrectly,
this may, in turn, lead to incorrect investment decisions. If the cost of capital is overstated,
the resulting NPV of a project may be shown to be negative, whereas, if the correct cost of
capital were applied to the cash flows, the NPV would be positive. Conversely, if the cost of
capital is understated, the resulting NPV of a project may be positive, whereas, if the correct
cost of capital were applied, the NPV may be negative. In this case, the investment should
not be undertaken.

4
 Corporate Finance – BA303

7. Ribbering plc is a property development company operating in London, United Kingdom.

The company has the following capital structure as at 30 November 2017:

£000
£1 ordinary shares 10,000
Retained profit 20,000
9% debentures 12,000
42,000

The equity shares have a current market value of £3.90 per share and the current level of dividend
is £0.20 per share. The dividend has been growing at a compound rate of 4% per annum in recent
years. The debentures of the company are irredeemable and have a current market value of £80
per £100 nominal. Interest due on the debentures at the year-end has recently been paid.

The company has obtained planning permission to build a new office block in a redevelopment
area. The company wishes to raise the whole of the finance necessary for the project by the issue
of more irredeemable 9% debentures of £80 per £100 nominal. This is in line with a target capital
structure set by the company where the amount of debt capital will increase to 70% of equity within
the next 2 years.

The rate of corporation tax is 25%.

(a) Explain 5 main factors which determine the cost of capital of a company.

(b) Calculate the weighted average cost of capital (WACC) of Ribbering plc which should be
used for future investment decisions.

Answers:

a) The main factors that determine the cost of capital of a company are as follows:

Business (or Activity) risk. These are risks associated with the nature of the business in which
the company is engaged. The higher the level of these risks, the higher the level of return
investors will require as compensation.

Financial risk. Where a company takes on gearing, it risks inability to make interest
payments and capital repayments when they fall due. Other things being equal, the higher
the level of gearing, the greater the level of risk for shareholders. As a result, shareholders
in highly geared companies are likely to demand higher returns than shareholders in low
geared ones.

Taxation. In the United Kingdom, interest payments in respect of loans attract relief from
corporation tax. In calculating the weighted average cost of capital of a company, the aftertax
cost rather than the pre-tax cost of interest payments is relevant. Thus, the cost of loan capital

5
 Corporate Finance – BA303

to the company will be determined, in part, by the relevant rate of corporation tax for the
period.

Inflation. During a period of inflation, the money rate of return required by investors is likely
to increase in order for investors to protect their real rates of return from investment.

Other investment opportunities. The required returns by investors in a particular company

will be influenced by the returns offered in similar types of investment opportunities.

Marketability of investment. Where shares are purchased in a public limited company that is
listed on a recognised stock exchange, it is relatively easy for investors to dispose of their
shareholdings when they so wish. However, shares of a private limited company are likely to
be more difficult to sell. As a result, investors in private limited companies are likely to
require a higher rate of return in compensation.

b) Weighted average cost of capital (WACC)

Cost of equity:

Ke = (D1/P0) + g = [(£0.20 x 1.04)/£3.90] + 0.04 = 0.093 = 9.3%

Cost of loan capital (after tax)

Kd = Interest (tax-adjusted)/Value of debt = [9(1-0.25)/80] x 100 = 0.084 = 8.4%

Weigthed average cost of capital (WACC)

Cost (%) Target Capital %

Structures
(Weights)
Cost of equity 9.3 100 58.8

Cost of debt 8.4 70 41.2

WACC = (0.093 x 0.588) + (0.084 x 0.412) = 0.055 + 0.035 = 0.09 = 9%

8. Supersonic plc manufactures machine tools. It has issued 2 million ordinary shares, quoted at
168 pence each, and £1 million 10% secured debentures quoted at par. To finance expansion, the
directors of the company want to raise £1 million for additional working capital. Cash flow from
trading before interest and tax is currently £1 million per annum. It is expected to rise to £1.3
million per annum if the expansion programme goes ahead. To simplify placing a value on the
company’s equity, you should assume that:

• The forecast level of cash flow, and a tax rate of 33%, will continue indefinitely.

6
 Corporate Finance – BA303

• The required rate of return on the market value of equity, 18% post-tax, will be unaffected
by the new financing.
• There is no difference between taxable profits and cash flow.

The company’s directors are considering 2 forms of finance – equity via a rights issue at 15%
discount to current share price, or 12% unsecured loan stock at par.

Required:
(a) Calculate for both financing options, the expected
(i) Increase in the market value of equity
(ii) Debt / (Debt + Equity) ratio
(iii) Weighted average cost of capital

(b) Assume you are the financial manager for Supersonic plc. Write a brief report to the board
advising which of the 2 types of financing is to be preferred. Include in your report brief
comments on non-financial factors which should be considered by the directors before
deciding how to raise the £1 million finance.

Answers :

Supersonic plc
(a)
(i) The current market capitalisation = (2m shares × £1.68) = £3.36m. The present value of
the cash flows from the investment project is (£0.3m [1 − 33%]/18%) = £1.12m (i.e., the NPV
is (£1.12m − £1m) = £0.12m). Under all-equity financing, market capitalisation should rise
by the full value of the project as it involves additional financing, that is, to (£3.36m + £1.12m)
= £4.48m.
If the finance is raised via borrowing at 12% p.a., the net cash flow will be:
(£0.3m − interest on £1m at 12%) [1 − 33%] = £0.12m p.a. At 18%, this has a PV of
(£0.12m/0.18) = £0.67m. On the assumptions given, this would be the increase in the market
capitalisation (i.e., the project is debt-financed). The new capitalisation is (£3.36m + £0.67m)
= £4.03m.
(ii) Assuming equity financing, gearing becomes (£1m/£4.48 + £1m) = 18.25%.
Assuming borrowed finance, gearing is £2m/(£4.03m + £2m) × 100 = 33.2%.

(iii) Assuming equity finance, the WACC is:

(10% [1 − 33%] × £1m/5.48m) + (18% × £4.48m/£5.48m) = (6.7% × 0.18) + (18% × 0.82) =
16.0%
Assuming borrowing, the WACC is:
(10% [1 − 33%] × £1m/[£4.03m + £2m]) + (12% [1 − 33%] × £1m/6.03m) + (18% ×
£4.03m/£6.03m) = (6.7% × 0.165) + (8.0% × 0.165) + (18% × 0.67) = 14.5%

(b) Report to: The Board of Supersonic plc

From: Financial Manager
Subject: Financing Alternatives
Date: 24 November 1998

7
 Corporate Finance – BA303

Introduction
At our recent meeting, you had instructed me to examine alternative ways, and
consequences, of raising an extra £1 million for working capital investment. Using the
assumptions we discussed, and assuming that the aim of the exercise is to maximise Market
Value-Added, that is, the excess of market capitalisation over funds provided by
shareholders, the borrowing alternative is superior. This offers an increase in the net value
of equity of £0.67 million, compared with only using equity of £0.12 million.

Reservation
However, the equity enhancement may be moderated by the stock market’s possible adverse
reaction to the increased level of capital gearing. As you know, increased gearing pre-empts
a greater proportion of earnings before interest and tax for interest payments, thus
increasing the volatility of the net after-tax earnings available to the shareholders. In an
efficient financial market, rational investors will demand higher rewards for bearing greater
risk, that is, the cost of equity will increase, possibly negating or reversing the decrease in
the WACC implied in my calculations. However, the increase in the discount rate applied to
shareholder earnings that would be required to eliminate the potential increase in the market
value of equity, would be implausibly substantial. Other issues
Debt may carry restrictions in the form of covenants. Long-term finance may be unnecessary
to fund working capital. The ‘Golden Rule’ of finance argues that short-term assets should
be financed by short-term means, for example, a bank overdraft facility that has greater
flexibility so far as interest is only paid on any balance overdrawn. A revolving credit facility
may be more suitable, as this is, in effect, a medium-term overdraft, and our requirement is
for medium-term finance.

Non-financial factors
Given that our need is for working capital, we should consider ways of shortening the
operating cycle and thus reducing our investment in working capital. This involves close
scrutiny of stock management and consideration of the extent to which, and how, we can
speed up collections and slow down payments to suppliers. We would need to canvass the
views of our major shareholders, especially concerning the acceptability of a rights issue,
given that it could dilute control. The future prospects for the economy have an important
bearing on our prospective level of sales, and hence ability to meet the interest payments out
of the operating cash flows. Volatility in cash flows will also depend on our level of operating
gearing. We might consider ways of eliminating some fixed operating costs, for example, by
outsourcing some activities. If you require further details on any of these points, please
contact me on my mobile.

Signed: Financial Manager

8
 Corporate Finance – BA303

9. The CFO of Yorkshire, wants to measure its cost of capital. Unfortunately, the company’s cost
of equity data is not available. The firm decided to use a surrogate firm i.e. Langdon plc which is
a firm in the same industry, for this purpose. He managed to produce 2 different discount rates. He
would like to find out if there are any errors in the cost of capital calculations. The cost of debt is
6%.

CAPM Estimate
Beta of Langdon: 1.2
Market portfolio return: 20%
Risk-free rate : 5%
Inflation : 3%

The cost of capital is 5% + (20% - 5%)1.2 = 23%.

The inflation-adjusted discount rate is 23% + 3% = 26%..

Dividend Growth Model Estimate

Langdon plc
Year Average share price Dividend per share
(pence) (pence)
2016 386 18.46
2017 218 20.12
2018 192 21.94
2019 232 23.9
2020 260 26.06

Ke = (D1/P) - g, where D1 is the expected dividend, P is the market price and g is the growth rate
of dividends ((28.40pence/150pence) – 0.09) = 9.93%). When inflation is included, the discount
rate is 12.93%. Other financial information on the 2 companies is presented here :
Yorkshire £000 Langdon £000
Fixed Assets 14,400 15,200
Current Assets 15,200 15,600
Less : Current Liabilities -7,800 -7,400
21,800 23,400
Financed by: 0 0
Ordinary equity
(£0.25) 4,000 3,600
Reserves 13,000 11,000
Bank Loans 4,800 8,800
21,800 23,400
Notes
1. The ex-dividend share price of Langdon plc is 150 pence.
2. Yorkshire’s board of directors has recently rejected a takeover bid of £12 million.
3. Corporate tax is paid at the rate of 30%.

9
 Corporate Finance – BA303

Required:
(a) Evaluate the 2 estimates of cost of capital and discuss any incorrect figures that exist.
Resolve this problem by giving new solutions based upon both methods. Put forward
clearly the assumptions in your discussion.

(b) Evaluate which of your revised estimates Yorkshire should use as the discount rate for
capital investment appraisal.

(c) Evaluate the assumptions of Modigliani-Miller Propositions. Which assumptions do you

think are not realistic ? Provide proper explanations to support your answers.

Answers:

(a) CAPM

ERj = Rf + βj(ERm – Rf) = 5% + 1.2(20%- 5%) = 23%

The CAPM’s E(R ) is inappropriate to be the discount rate due to the following:

(i) It is the required return on equity that matters rather than the required return on
the overall company.
(ii) The equity beta of 1.2 reflects the financial risk of Langdon’s equity. Yorkshire’s
gearing is different from that of Langdon. Therefore, their equity betas is different.

There is no need to adjust for Inflation because the ERm and Rf already incorporate
the expected impact of inflation. The equity beta for Yorkshire can be estimated by
ungearing Langdon’s equity beta and regearing to reflect the financial risk of
Yorkshire. The market value-weighted gearing figures are:

Langdon
Equity (150 pence x 14.4 million shares) = £21.6 million, i.e. 71.05% of total
Debt = £8.8 million i.e. 28.95% of total
Total = £30.40 million

Yorkshire
Equity (using the takeover bid offer) = £12 million, i.e. 71.43% of total
Debt = £4.8 million, i.e. 28.57% of total
Total = £16.8 million

Assuming corporate debt is risk-free, the ungeared equity beta is

βu = βg x (1/[1+(VB/VS)(1-T)] = 1.2 x [1/[1+(0.407)(1-30%)] = 0.93

Regearing Beta for Yorkshire,

βg = βu[1+(VB/VS)(1-T)] = 0.93 [1 +0.4(1 – 30%)] = 1.19
The cost of equity for Yorkshire is thus :

10
 Corporate Finance – BA303

5% + 1.19[20% - 5%] = 22.85%

Given the cost of debt is 6%:

WACC = [6%(1 – 30%) x 28.57%] + [22.85% x 71.43%]
= 1.20% + 16.32% = 17.52%

However, the WACC is only suitable as a discount rate if the systematic risk of the new
investment is similar to that of the company as a whole.

Dividend Growth Model

The expression for this model relates to the cost of equity, not the overall cost of capital, i.e.

Ke = D1/P0 + g = 28.40pence/150pence + 9% = 27.93%

No inflation adjustment is required.

The WACC is: [6%(1 – 30%) x 28.57%] + [27.93% x 71.43%] = 1.20% + 19.95% = 21.15%

(b) The revised CAPM estimates should be used as the discount rate for capital budgeting
because this method considers the market risk, beta in determining the cost of equity.
The Dividend Growth Model does not consider the influence of beta, therefore, the cost
of equity measurement is less accurate. Beta is an important variable/factor that
determine the required rate of return for any security including equity and this has
been proven by many scientific research in finance. Excluding it is not a choice.

(c) The unrealistic assumptions of MM are as the following :

There are neither personal nor corporate income taxes : This is not true. Taxes do exist
in most countries around the world.
There are no brokerage or transaction costs : This is not true. There are transaction
costs in this world such as brokerage commission, etc and we have to consider it.
Investors are all rational wealth-seekers : This is not true. Some investors invest
charitably but some investors are extremely vigilant and they invest carefully.
Investors formulate similar expectations about future company earnings : This is not
true as different investors have different expectations about their investments’ future
rate of return and future corporate earnings.
The assets of an insolvent firm can be sold at full market values (i.e. no distress costs):
Not true. Most of the time, they may not be able to recover the full market value because
usually these assets are sold at firesale prices.

11