The Effect of Capital Structure on the Value of the Firm - Assignment Example

Finance past Paper Answers Finance past Paper Answers Past Paper Question 13 Part a The effect of capital structure on the value of the firm depends on the environment assumed in the analysis process. Generally, according to hypothesis, the firm’s investment policy is not fixed (considering the fact that shareholders have expressed their need for 20% return on equity). Therefore, resulting cash flow will be affected by company’s change in capital structure. Part b Return on equity will be increased since leverage increases risk of shareholders. Increase in ROE is aimed at compensating higher risks. ROE=net income/shareholder’s equity Previous ROE= (35000000-15000000)/0.20 = 100 Million New ROE = (40000000-15000000)/0.20 = 125 Million Part c Beta=1, 45 Treasury bills yield=5% Expected return of market portfolio=14% Asset debt=35% Yield to maturity=9% Tax bracket (margin) =35% WACC = 14% × (35% + (1.45*9)) × 5(1-35%) = 22.0675% Question 14 Part a One of the major controversies surrounding dividend policy is the question of whether dividends are capable of increasing firm value. Three divergent and broad perceptions have emerged while tackling the question. Before the adoption of findings of MM (Modigliani and Miller), previous wisdom stated that increase in dividend payouts increased the value of firms. MM’s argument stated that the value of the firm is based on the success of investments, but not how dividends are allocated. A more rational perception affirms that considering, capital gains and dividends differential taxation, dividends tend to reduce the value of firms due to higher taxation rates. MM’s irrelevancy in dividend argument assumes capital markets are perfect. Direct challenge was posed by MM’s argument against the old opinion of dividend on the value of firm. As debates continue, the basic belief of MM has been accepted more than the traditional perceptions of dividends. I strongly believe that MM’s argument provides the best policy in terms of dividend payouts. Financial managers need to understand the wisdom involved in reinvesting excess funds instead of paying them out as excess earnings. Invested funds may be profitable for both the company and shareholders. Part b I. WACC =E/V*Re+D/V*Rd*(1-Tc) WACC = 10% E = 50M V = 50M Re=equity cost Rd = 0 To find share price’ X = 10/1 = 10 Therefore, market value = shares outstanding*share price = 10M*10 = 100M Outstanding shares=10,000,000 Share price=10 Total Debt=0 Total Cash=10,000,000 Therefore, EV=Market cap + total debt-Cash = 100,000+0-10,000,000=90,000,000 II. Regular yearly dividend amount is: 10+ (50M/10M) =£15 for Year 1 15+ (40M/10M) =£19 for tYear 2 19+ (40M/10M) =£23 for year 3 III. Ex-dividend Price = share price at the close of trade – dividend = 10-15 = -£5 IV. Reinvesting £50M, Year 1 dividend=10+ (40M/10M) =£14 Year 2 dividend=14+ (40M/10M) =£18 Year 3 dividend=18+ (40M/10M) =£22 2012 Past Paper Question 11 Part a I. IRR rule asserts that if the IRR on an investment or project is larger than the required minimum rate of return (or the capital cost), then it is advisable to proceed. Conversely, in case investment or project’s IRR is lower than capital cost, it is advisable to reject. NPV=CF-n(Cf/1+IRR)n NPV=20,000 CF=22,000 Minimum rate of return=8/12 = 0.67% Calculating IRR, 0=20,000 -12(22000/1+IRR) 0=20,000-264,000+264,000IRR 244,000=264,000IRR IRR=0.92% Comparing IRR to capital cost, IRR is greater thus it is advisable to proceed with the purchase. II. Prevent Value = -20,000 Using 22,000 next year, PV=22,000/(1+0.08)1 = 22,000/1.08=20,370.37 NPV=20,370.37-20,000=£370.37 Therefore, at discount of 8%, the investment NPV = £370.37 The NPV rule states that an invested or project should be accepted in the event that the NPV is greater than 0; otherwise, the condition is rejected. Therefore, the decision made in the previous answer is correct. III. IRR rule does not apply considering the disposal costs incurred that exceeds the cash flow and present values. In this case, the company needs to use the power of compounding in evaluating the efficacy of investing. Part b The policy states that if the return of incremental IRR is higher than the least (minimum) acceptable return rate, the better investment will be the more expensive option. Determining the IRR of premium widget option, 0=36,000,000 -24(44,000,000/1+IRR) 0=36,000,000 -1,056,000,000(1+IRR) 0=36,000,000 -1,056,000,000+1,056,000,000IRR 1,020,000,000=1,056,000,000IRR IRR=0.97% Using the incremental IRR principle, the best option is the premium widget. Question 12 Part a Year Treasury Bill % Market portfolio % Utility Company % High-Tech % Counter-cyclical % 2001 4 -2 6 -5 26 2002 4 5 7 2 16 2003 4 10 9 15 12 2004 4 15 11 25 -9 2005 4 25 14 45 -20 Average 4 10.6 9.4 16.4 5 Excess Return -6.6 N/A -1.2 5.8 -5.6 Part b Year Treasury Bill % Market portfolio % Utility Company % High-Tech % Counter-cyclical % 2001 4 -2 6 -5 26 2002 4 5 7 2 16 2003 4 10 9 15 12 2004 4 15 11 25 -9 2005 4 25 14 45 -20 Average 4 10.6 9.4 16.4 5 Excess Return -6.6 N/A -1.2 5.8 -5.6 Historical Return (Dividend Yield+Capital Gain) or Excess return+Average return (4+-6.6)=-2 Assumption: poor proxy of the securities expected return 10.6 Assumption: good proxy of securities expected return 7.4 Assumption: good proxy 22.2 Assumption: good proxy -0.6 Assumption: poor proxy of the securities expected return Part c Year Treasury Bill % Market portfolio % Utility Company % High-Tech % Counter-cyclical % 2001 4 -2 6 -5 26 2002 4 5 7 2 16 2003 4 10 9 15 12 2004 4 15 11 25 -9 2005 4 25 14 45 -20 Average 4 10.6 9.4 16.4 5 Excess Return -6.6 N/A -1.2 5.8 -5.6 Historical Return (Dividend Yield+Capital Gain) or Excess return+Average return (4+-6.6)=-2 Assumption: poor proxy of the securities expected return 10.6 Assumption: good proxy of securities expected return 7.4 Assumption: good proxy 22.2 Assumption: good proxy -0.6 Assumption: poor proxy of the securities expected return Covariance 0 N/A 25.96 160.16 -150.4 Beta Beta=covariance/market variance 0 Beta interpretation: market and security returns move independently. n/a 0.2 Beta interpretation: stock price relatively unaffected by market return swings 1.5 Beta interpretation: the stock is highly volatile. -1.4 Beta interpretation: there is a negative return in stock but a positive return in market Part d Year Treasury Bill % Market portfolio % Utility Company % High-Tech % Counter-cyclical % 2001 4 -2 6 -5 26 2002 4 5 7 2 16 2003 4 10 9 15 12 2004 4 15 11 25 -9 2005 4 25 14 45 -20 Average 4 10.6 9.4 16.4 5 Excess Return -6.6 N/A -1.2 5.8 -5.6 RRR 0 N/A -0.24 8.7 7.84 i. The graph represents CAPM (Capital Asset Pricing Model) ii. CML does not use beta in determination of risk factors. Part e Overvalued securities: High-tech and countercyclical Undervalued security: Utility Company Properly valued: Treasury bill and Market Index Undervalued securities are plotted above SML, an indication of investors’ expectations for greater returns. Overvalued securities are blotted below SML since investors will possibly accept fewer returns for risks assumed. Part f It is important to avoid pulling the entire investment into one sector or stock. An individual needs to create a mutual fund by investing in different companies he or she trusts, knows, and use. Bonds and index funds need to be considered as better investment solutions. Fixed income or index funds should be added to the whole mix. The best long-term portfolio diversification lies on tracking various indexes. Dollar-cost averaging are also important in portfolio diversification since it smoothens valleys and peaks of market volatility. Question 13 Part a Facts, At date 0, initial outlay = 150,000 Date 1, single cash flows for strong economy = 300,000 Single cash flows for weak economy = 140,000 WACC (cost of capital) = 10% Risk free rate of return = 5% Maket value = PV of cash flow at WACC = 150,000*10%=157,500 Part b To calculate market value, it is important to determine the new WACC Facts, Re=5% Rd=5% E=100,000 (150,000-50,000) D=50,000 V=150,000 D/V=66.7% E/V=33.3% (1-Tc)=(1-(2500*100/300,000)=0.83 Therefore, WACC=(33.3%*5%)+(66.7%*5%*0.83)=0.044(4.4%) Market Value=150,000*1.044 = 156,600 Part c Expected return of all-equity-funded company Expected return = 157500-150,000 = 7,500 Expected return of levered company Expected return = 156600-150000 = 6,600 Both returns indicate positive values. However, the returns of all equity funded are higher. The explanation behind this is that leveraging the capital structure using debts reduces the amount of returns because of debt repayments and interest rates charged on the single cash flow. Part d Using MM model II, levered equity’s capital cost equals the capital cost of unlevered security plus market premium proportional too debt-equity ratio of market value. That is: rE=rU+D/E(ru-rD) Part e 1. With issuance of debt, it is important to note that interest charged on the debt is deductible as tax; therefore, debt cost will be adjusted to show this deductibility. The debt cost (before tax) is multiplied by factor 1-t (t represents marginal tax rate). Payments to shareholders are not deductible; therefore, the cost of capital will be the return on equity (common or preferred). Underlying assets can be valued using this approach. 2. Conflicts between these two groups emerge as a result of incorrect pricing of the firm’s equity. Funding a new project (by issuing a new equity) often lead to incorrect valuing of the securities of main holders. As a result, new investors are better placed at getting higher values than NPV of the project. 3. For a single period, there are 2 dates: t=0 and t=1 Thus, stock price will only have 2 possible values (either up or down) Binomial option: The value of d=35% (0.35) Value of u=5% (0.05) Option 1: 150000(1+0.35) = 202,500 Option 2: 150000(1+0.05) = 157,500 Put-call parity: Time for expiration = 1 yr Option 1: Max{157500-150000 , 0} Option 2: Max{202500-150000 , 0} Question 14 Part a Real options are important in identifying the issues associated with uncertainty and risks of investment evaluation. Investment decision-makers tend to rely on instincts in the process of finalizing their decisions. The use of real options in investment decisions helps in identifying investments requiring deferment to a later date. It is also vital in understanding the possibility of using partial investments in uncertain markets. The traditional discounted cash flow models such as NPV and ROI have failed to address measures of uncertainties in different types of investments. The main types of ROA (real options analysis) include binomial and put-call techniques. Part b 1) Value = 200*75(1.12)*1.01=18.5billion 2) Without using the investment, value = shares outstanding*share price WACC = 10% E = 50M V = 50M Re=equity cost Rd = 0 To find share price’ X = 10/1 = 10 Therefore, market value = shares outstanding*share price = 50M*10 = 500M 3) NPV of expansion=CF-n(Cf/1+IRR)n=200-12(75/1+0.12)=-603.57 4) Using 200 million to repurchase cash would have realized higher returns because of the evident increase in cash flow and a positive IRR. Reinvesting in stocks is better considering that it gives the higher stock price compared to expansion. Read More