Department

of Accounting and Finance

MSc Programmes

AG915: Advanced Corporate Finance & Applications

AG917: Topics in Corporate Finance

Workshop 2 Solutions

Dick Davies
January 2017
 WACC and Valuation -Traditional Perspective
Cost of capital Cost of Equity

WACC
0.20
Cost of Debt
0.08

Debt / Equity
Optimal Debt/Equity
Value Ratio

Value of Company
1
V0 = X
k
1
X = V0 inverse relationship between value and the discount rate
k
Debt / Equity
Optimal Debt/Equity
2 Ratio
 The Cost of Equity, the Cost of Debt, and the Weighted Average Cost of Capital:
MM Proposition II with No Corporate Taxes

Cost of capital:

BG
k e = kU + ( kU - k i )
SG

BG SG
kU W A C C = kO = ki + ke
BG + SG BG + SG

ki ki

BG
Debt-to-equity Ratio
3 SG
 Question 1: Tartan plc (Introduction of Gearing)
Tartan plc has always followed a policy of avoiding any debt financing. But
the company needs to raise an additional 26m to finance a major project and
is considering the issue of bonds at 9 per cent. Alternatively it could sell 13
million additional shares at the prevailing market price of 2. This would
increase the number of shares outstanding to 30 million. The annual earnings
following the investment in the new project are expected to be 20m before
tax. The company is not expected to be able to generate any other
investments that will be worth exploiting and expected earnings are expected
to remain constant indefinitely into the future. One of the advantages of
employing debt would be the tax savings associated with the interest
expense. The tax rate is 40 per cent. But it is also recognised that earnings
could fall below the expected level in any one period.

No of shares outstanding ( N 0 ) 17m

Proposed issue of shares (DN ) 13m
Price per share 2m
Additional Funding Required 26m
Question 1 a Solution
a) Calculate the expected earnings per share for both financing
possibilities.

Expected earnings before interest and tax 20 20

Interest (0.09 x26m) 0 -2.34
Earnings before tax 20 17.66
Tax(40 per cent) -8 -7.064
Profit after tax 12 10.596
Number of shares outstanding 30 17
Expected earnings per share (EPS) 0.400 0.623
 Question 1 b Solution
b Calculate the level of earnings at which earnings per share
would be the same for both financing possibilities.
Let the level of earnings (profit) at which the expected earnings per share
would be the same for both financing options be X * .

( )
X * (1 - tc ) X * - ki BG (1 - tc )
=
N 0 + DN N0
( )
X * (1 - 0.4 ) X * - 0.09 26m (1 - .4 )
=
30m 17 m
Cancel the tax factors and cross multiply
17 X *m = 30 X *m - 70.2m
13 X *m = 70.2m
X * = 5.4m
Question 1 b Check answer

Expected earnings before interest and tax 5.4 5.4

Interest (0.09 x26m) 0 -2.34
Earnings before tax 5.4 3.06
Tax(40 per cent) -2.16 -1.224
Profit after tax 3.24 1.836
Number of shares outstanding 30 17
Expected earnings per share (EPS) 0.108 0.108
The overall capital employed is 60m (30m shares at 2.00) and to produce the same
EPS for the two financing options will require the rate of return on the capital to be
equal to the interest rate (0.09 x 60m = 5.4m). If the rate of return on capital
employed is equal to the interest rate the component of the capital funded by debt
does not create a surplus or deficit for the shareholders. This implies that the EPS
will be the same whether the financing is by debt or equity.
 Question 1c
As the earnings per share are expected to be greater if debt financing
is employed does this imply that the new project should necessarily
be financed by debt?
In a word no! The earnings per share for the geared option is
riskier than that for the ungeared option, and consequently are
not directly comparable. Rather than consider the impact on
the earnings per share figure the company should focus on the
cost of capital in the assessment of financing options. Lastly,
the earnings per share figure for one year might be misleading
if we drop the convenient assumption that expected earnings
are unchanged indefinitely into the future the perpetuity
assumption is convenient but not always appropriate.
 Question 2a
Araf Plc has run into cash flow problems recently as a result of a fall in sales caused by
an economic recession and is having difficulty servicing its debts. The company has
discussed the possibility of a rights issue with its investment bank and it has been
agreed that this is the most appropriate way of dealing with its problems. The
investment bank has warned the CEO that the company should anticipate that the
announcement of the issue is very likely to produce a negative reaction in the market.
When the companys board of directors is told this some directors oppose the proposed
issue on the grounds that it will push down the share price and this will not be in the
shareholders interest. As the CEO respond to these concerns of the shareholders.
 Question 2a Solution
Araf Plc has run into cash flow problems recently as a result of a fall in sales caused by
an economic recession and is having difficulty servicing its debts. The company has
discussed the possibility of a rights issue with its investment bank and it has been
agreed that this is the most appropriate way of dealing with its problems. The
investment bank has warned the CEO that the company should anticipate that the
announcement of the issue is very likely to produce a negative reaction in the market.
When the companys board of directors is told this some directors oppose the proposed
issue on the grounds that it will push down the share price and this will not be in the
shareholders interest. As the CEO respond to these concerns of the shareholders.
If the companys shares are overvalued as a result of the market being
unaware of the companys cash flow problems, particularly if these problems
are indicative of even more fundamental difficulties, the share price will
eventually fall anyway. Any expected fall is not the result of the issue of new
shares, but the consequence of the basic problems facing the company. A
failure to raise the funds may result in even more problems and an even
lower value for the company. Despite the possibility of a fall in the share price
the company may need to proceed with the issue and to keep the market
informed of its position and intentions.
 Question 2b Solution
Explain why information asymmetry may explain the average market response to cash
offers to raise funds but are not so likely to explain the average market response to the
announcement of a rights issue.

The information asymmetry based on the different information available to

managers and investors assumes that the investors believe that managers
will exploit their added information. They assume that the managers will
only issue shares to outside investors when they are overvalued. If they
achieve this it will benefit their existing shareholders. In the case of a rights
issue the shares are sold to insiders and consequently there are no external
investors to exploit on their behalf.
 Question 3
Miller plc is expected to produce earnings next year of 18m and it is anticipated that it will be able to
maintain this level of earnings indefinitely into the future. The company is financed entirely by equity
and has a market value of 150m. The companys management is considering the possibility of issuing
debt of 50m and it has been established that this can be done at an interest rate of 6 per cent. The
proceeds would be used to buy back 50m worth of its equity.

Determine the cost of equity capital and the weighted average cost of capital for the
company if its capital structure is restructured to include debt of 50m. Use both the
traditional and Modigliani-Miller approaches in answering the question. Assume there
are no corporate taxes.
Question 3 Answer (1)
VU = 150m BG = 50m

Traditional Approach
The cost of geared equity, ke , and the cost of debt, ki , are assumed to be
remain constant over limited amounts of debt assume 50m constitutes a
limited amount of debt in this context -
where kU = X = X = 18m = 0.12 = ke the cost of equity capital for an
SU VU 150m
ungeared company with constant expected earnings

The cost of equity is assumed to remain constant as debt is substituted for
equity financing as there is no perception of any increase in equity risk until
the level of debt increases to the point where it is thought to be a good
chance of it leading to the firms bankruptcy at some stage in the future. The
increase in equity risk in the form of the added variability of returns is not
recognised
Question 3 Answer (2)

Traditional Approach
SG BG
WACC = k e + ki
SG + B G SG + B G
100m 50 m
= 0.12 x + 0.06 x = 0.10
100m + 50 m 100m + 50 m

Modigliani - Miller Approach

B 50 m
k e = kU + (kU - ki ) G = 0.12 + (0.12 - 0.06) = 0.15
SG 100m
SG BG
WACC = k e + ki
SG + B G SG + B G
100m 50 m
= 0.15 x + 0.06 x = 0.12 = kU
100m + 50 m 100m + 50 m
Question 4
Alban plc and Bruce plc are companies with identical assets and expected cash flow.
Alban is financed entirely by equity whereas Bruce employs some debt capital. Alban
has 100 million shares outstanding and these are trading at 6.00 per share. Brice
employs debt of 150 million and has 75 million shares outstanding. The interest rate
on the dent is 8 per cent and the companys expected earnings are 96 million.

a) Based on the analysis developed by Modigliani and Miller (with no taxes)

determine the equity cost of capital for both Alban and Bruce.

b) Determine the weighted average cost of capital for both companies.

Question 4: Solution
Given M - M assumptions
VA = VB = PA xN A = 6.00 x100m = 600m
VB = SG + BG SG = VB - BG = 600m - 150m = 450m

X 96m
kUA = = = 0.16 = WACC A
VA 600m
X - ki BG 96m - 0.08 x150m 84m
keB = = = = 0.186
V
SG B 450 m 450 m
Equity Debt
WACC B = kOB = keB + ki
Equity + Debt Equity + Debt
450m 150m
= 0.186 + .08 = 0.16
600m 600m
= 0.16
WACC A = WACC B = 0.16
Question 5
In an economy characterised by perfectly competitive markets an un-geared
company with expected earnings in perpetuity of 100m is valued in the market
at 500m. An equivalent company that employs 200m debt, issued at 10 per
cent, is valued at 600m. A shareholder owns 20 per cent of the geared
companys equity. Demonstrate that the shareholder will benefit from selling
her shares and borrowing and investing in the un-geared company.
Question 5 Solution
Given M - M assumptions
VU = 500m VG = SG + BG = 600m SG = VB - BG = 600m - 200m = 400m
Shareholder owns 0.20x SG = 0.20x 400m = 80m
Shareholder sells shares to realise 80m
Shareholder borrows 0.20 BG = 0.20 x 200m = 40m
Total shareholder funds to invest in the ungeared equity = 120m

Earnings from the initial investment in G

YG = 0.20 x EAE (G) = 0.20 (X - k i ) = 0.20 (100 - 0.10 x 200) = 16
New ownership of the ungeared
Earnings from the investment in U firm = 120/500 = 24%
YU = 0.24 x (X) - k i B personal = (0.24 x 100) - ( 40 x 0.10) = 20

YU > YG and the risk is the same as the personal borrowing produces the same ratio
of debt to equity for the investor as is employed by the geared company.
This should lead to the sale of shares in G and the purchase of the shares in U, leading to a
fall in the value of the equity of G and an increase in the value of the equity of U.
This will continue until VG = VU .
Question 6
Dunbar plc is financed entirely by equity and its expected earnings before interest and
tax is 180m and the tax rate is 30 per cent. Its equity is valued at 840m.

a) Determine the required rate of return on the ungeared equity.

b) Specify Dunbars cost of equity using the capital asset pricing model. Assume a risk
free rate of 7 per cent and an expected return on the market of 13 per cent. ( The
companys beta is 1.25.

c) Now assume that the company restructures its financing to employ 300 of debt.
Determine the value of the company and its equity, recognising the tax advantages
of debt.

d) The interest rate on the debt is 7 per cent as it is risk free. Determine the companys
cost of equity capital and its overall cost of capital derive both using different
approaches (equations).
 Question 6 Answers
Dunbar plc is financed entirely by equity and its expected earnings before interest and tax is
180m and the tax rate is 30 per cent. Its equity is valued at 840m.

a) Determine the required rate of return on the ungeared equity.

Given M - M assumptions
VA = VB = PA xN A = 6.00 x100m = 600m
VB = SG + BG SG = VB - BG = 600m - 150m = 450m

X (1 - tC ) 180m(1 - 0.30)
kU = = = 0.15 = k0
VA 840m

b) Specify Dunbars cost of equity using the capital asset pricing model. Assume a risk
free rate of 7 per cent and an expected return on the market of 13 per cent. ( The
companys beta is 1.33.)

E ( RU ) = RF + bU ( E ( RM ) - RF ) = 0.07 + 1.33(0.13 - 0.07) = 0.15

 Question 6 Answers
c) Now assume that the company restructures its financing to employ 300 of debt.
Determine the value of the company and its equity, recognising the tax advantages
of debt.

VG = VU + tC BG = 840m + 0.30 x300m = 930m

SG = VG - BG = 930 m - 300m = 630m SG = VU - BG + tC BG = 840m - 300m + 90m = 630m

d) The interest rate on the debt is 7 per cent as it is risk free. Determine the companys
cost of equity capital and its overall cost of capital derive both using different
approaches (equations).
ke = kU + (kU - ki )(1 - tC ) BG / SG = 0.15 + (0.15 - 0.07)(1 - 0.30)300m / 630m = 0.176
( X - ki BG )(1 - tC ) (180m - 0.07 x300m)(1 - 0.30) 111.30m
keB = = = = 0.176
SG 630m 630m

Equity Debt
WACCG = kO = ke + ki (1 - tC )
Equity + Debt Equity + Debt
630m 300m
= 0.176 + 0.07(1 - 0.30) = 0.135
930m 930m
X (1 - tC ) 180m(1 - 0.30)
WACC = = = 0.135
VA 930m