FRA TUTORIAL 4 CAPITAL STRUCTURE

(1)
LTD/Equity = 200m/25m = 800%
LTD/(LTD + Equity) = 200m/(200m + 25m) = 88.89%
Total Debt/Equity = (800m + 200m)/25m = 4,000%
Net Debt = (800m + 200m) (120m + 300m) = 580m
Net Debt/Equity = 580m/25m = 2,320%
Interest Cover = 200m/150m = 1.33 times
Income Gearing = 1/1.33 = 75.19%
Total Debt/Total Assets = (800m + 200m)/1,500m = 66.67%
Total Liabilities/Total Assets = 1,400m/1,500m = 93.33%
(2)
(a)
The interest payments each year will be:
Interest payment = 0.12(80,000) = 9,600
This is exactly equal to the EBIT, so no cash is available for shareholders.
Value of Equity

=0

Since the market value of the companys debt is 80,000, and there is no probability of default, the
total value of the company is the market value of debt.
Debt/Value Ratio is

80,000
80,000 +0

(b)
At a 5 percent growth rate, the earnings next year will be:
Earnings next year

= 9,600(1.05) = 10,080

So, the cash available for shareholders is:

Payment to shareholders

= 10,080 9,600
= 480

Since there is no risk, the required return for shareholders is the same as the required return on the
companys debt.
The payments to shareholders will increase at the growth rate of five percent (a growing perpetuity),
so the value of these payments today is:
Value of Equity

= 480 / (0.12 0.05)

= 6,857

Debt/Value Ratio

= 80,000 / (80,000 + 6,857)

= 0.92

(c)
At a 10 percent growth rate, the earnings next year will be:
Earnings next year

= 9,600(1.10) = 10,560

So, the cash available for shareholders is:

Payment to shareholders

= 10,560 9,600
= 960

Value of Equity

= 960 / (0.12 0.10)

= 48,000

Debt/Value Ratio

= 80,000 / (80,000 + 48,000)

= 0.63

Summary

Profit/
Dividend Growth
0%
5%
10%

Equity Value
0
6,857
48,000

Debt to Value Ratio

1
0.92
0.63

As the level of profits increase, so too follows the equity value and inversely the debt to value ratio.

(3)
(a)
The total value of a firms equity is the discounted expected cash flow to the firms shareholders.
If the expansion continues, each firm will generate earnings before interest and taxes of 10 million.
If there is a recession, each firm will generate earnings before interest and taxes of only 500,000.
Abbeycrest Plc
Since Abbeycrest owes its debt holders 2m at the end of the year, its shareholders will receive 8
million (= 10m 2m) if the expansion continues.
If there is a recession, its shareholders will receive no dividends (= 0.5m 2m).
Since the Cost of Capital is 15 percent, the market value of Abbeycrests equity is:
SAbbeycrest = [(0.5 x 8m) + (0.5 x 0m)] / 1.15
= 4m / 1.15
= 3.48m
Abbeycrests debt holders will receive 2m whether there is a recession or a continuation of the
expansion. So, the market value of Abbeycrests debt is:
BAbbeycrest = [(0.5 x 2m) + (0.5 x 2m)] / 1.15
= 2m / 1.15
= 1.74m
Kingspan Plc
Since Kingspan owes its debt holders 1 million at the end of the year, its shareholders will receive
9 million (= 10m 1m) if the expansion continues.
If there is a recession, its shareholders will receive nothing since the firms debt holders have a more
senior claim on all 800,000 of the firms earnings. So, the market value of Kingspans equity is:
SKingspan

= [(0.5 x 9m) + (0.5 x 0)] / 1.15

= 4.5m / 1.15
= 3.91m

Kingspans debt holders will receive 1 million if the expansion continues or if there is a recession.

So, the market value of Kingspans debt is:

BKingspan

= [(0.5 x 1m) + (0.5 x0.5m)] / 1.15

= [0.5m + 0.25m] / 1.15
= 0.65m

Summary

Abbeycrest Plc

Equity Value
3.48m

Debt Value
1.74m

Total Value
5.22m

Kingspan Plc

3.91m

0.65m

4.56m

Since Abbeycrest has a higher gearing, it also has a higher debt value and a lower equity value than
Kingspan.