ExAns-Ch16

8/13/2019 ExAns-Ch16

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Chapter 16 Capital Structure

Answer – Test your understanding 1

The traditional view of capital structure – (d)

M&M without tax – (a)

M&M with tax – (c)

Diagram (b) does not accord with any of the theories.


The !"" will remain the same# M&M – no tax (see above).

$ $ecause the returns to shareholders become more volatile. (%ote# this is not

ust an M&M view but true of all the approaches to gearing).

" The company which had geared up# M&M – with tax (see above).

D Debt 'ecingorder theory.


The discount rate that should be used is the !""* with weightings based on maret

values. The cost of capital should tae into account the systematic ris of new

investment* and therefore it will not be appropriate to use the company+s existing

e,uity beta. -nstead* the estimated e,uity beta of the main erman competitor in the

same industry as the new proposed plant will be ungeared* and then the capital

structure of $acwoords applied to find the !"" to be used for the discount rate.

/ince the systematic ris of debt can be assumed to be 0ero* the erman e,uity beta

can be 1ungeared2 using the following expression.

)3( T V V V d e

eea

−+

×= β β

4or the erman company#

567.38)753(95:5

:5;.3 =

−×+

×=aβ

The next step is to calculate the debt and e,uity of $acwoods based on maret

values.

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<m

=,uity 9;5m shares at 7>:p 3*:?6.5

Debt# ban loans (635 – >;) 37;.5

Debt# bonds (>;m x 3.65) ?5.5

Total debt 66;.5

Total maret value 3*?3>.5

The beta can now be regeared#

[email protected]:?6*3

8))753(66;:?6*3(567.3 =

−×+×= g β

This can now be substituted into the "'M to find the cost of e,uity.

A e B >.>;8 C (39.;8 – >.>;8) x 3.33@ B 3;.758

The !"" can now be calculated#

89.39?3>*3

?58?

?3>*3

37;8>

?3>*3

:?6*387.3; =

×+

×+

×

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Examination Style Questions

Answer 1

(a)

"alculation of weighted average cost of capital (!"")

Maret values

Maret value of e,uity B ;m x 9.;5 B <66.; million

Maret value of preference shares B 6.;m x .5>:6 B <3.?5; million

Maret value of 358 loan notes B ;m x (35;355) B <;.6; million

Total maret value B 66.;m C 3.?5;m C ;.6;m B <6?.:;; million 2 mar!s"

"ost of e,uity using dividend growth model B E(7; x 3.59) 9;5F C 5.59 B 36.5@8 2 mar!s"

"ost of preference shares B 355 x ? >:.6 B 33.@38 1 mar!"

nnual aftertax interest payment B 35 x 5.> B <>

Gsing interpolation* aftertax cost of loan notes B ; C E(; x >.?9)(>.?9 C 65.?:)F B :.7>8

2 mar!s"

!"" B E(36.5@ x 66.;) C (33.@3 x 3.?5;) C (:.7> x ;.6;)F 6?.:;; B 33.5;8 2 mar!s"

(b)

3. Droxfol "o has longterm finance provided by ordinary shares* preference shares and

loan notes. The rate o# return re$uired %y each source o# #inance depends on its ris!from an investor point of view* with e$uity (ordinary shares) being seen as the most

ris!y and de%t (in this case loan notes) seen as the least ris!y. -gnoring taxation* the

weighted average cost of capital (&ACC) would therefore be expected to decrease as

e$uity is replaced %y de%t* since de%t is cheaper than e$uity* i.e. the cost of debt is

less than the cost of e,uity. 1 mar!"

6. However* #inancial ris! increases as e$uity is replaced %y de%t and so the cost o#

e$uity will increase as a company gears up * o##setting the e##ect o# cheaper de%t. t

low and moderate le'els o# gearing* the %e#ore(tax cost o# de%t will %e constant* but

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it will increase at high le'els o# gearing due to the possi%ility o# %an!ruptcy. t high

levels of gearing* the cost o# e$uity will increase to re#lect %an!ruptcy ris! in

addition to financial ris.

7. -n the traditional 'iew o# capital structure* ordinary shareholders are relatively

indi##erent to the addition o# small amounts o# de%t in terms of increasing financial

ris and so the &ACC #alls as a company gears up.

9. s gearing up continues* the cost o# e$uity increases to include a #inancial ris!

premium and the &ACC reaches a minimum 'alue. $eyond this minimum point* the

!"" increases due to the effect of increasing financial ris on the cost of e,uity and*

at higher levels of gearing* due to the effect of increasing banruptcy ris on both the

cost of e,uity and the cost of debt. )n this traditional 'iew* therefore* *rox#ol Co can

gear up using de%t and reduce its &ACC to a minimum * at which point its mar!et

'alue (the present value of future corporate cash flows) will be maximised.

;. -n contrast to the traditional view* continuing to ignore taxation %ut assuming a

per#ect capital mar!et* +iller and +odigliani demonstrated that the &ACC

remained constant as a company geared up* with the increase in the cost o# e$uity

due to #inancial ris! exactly %alancing the decrease in the &ACC caused %y the

lower %e#ore(tax cost o# de%t. /ince in a pre#ect capital mar!et the possi%ility o#

%an!ruptcy ris! does not arise* the &ACC is constant at all gearing le'els and the

mar!et 'alue o# the company is also constant. Miller and Modigliani showed*

therefore* that the mar!et 'alue o# a company depends on its %usiness ris! alone *

and not on its #inancial ris! . In this view* therefore* Droxfol "o cannot reduce its

!"" to a minimum.

:. !hen corporate tax was admitted into the analysis of Miller and Modigliani* a

different picture emerged. The interest payments on de%t reduced tax lia%ility* which

meant that the &ACC #ell as gearing increased* due to the tax shield given to profits.In this view* *rox#ol Co could reduce its &ACC to a minimum %y ta!ing on as

much de%t as possi%le.

, – - mar!s"

>. However* a per#ect capital mar!et is not a'aila%le in the real world and at high le'els

o# gearing the tax shield offered by interest payments is more than o##set %y the

e##ects o# %an!ruptcy ris! and other costs associated with the need to service large

amounts of debt. Droxfol "o should therefore be a%le to reduce its &ACC %y gearing

up* although it may %e di##icult to determine whether it has reached a capital

structure gi'ing a minimum &ACC.

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1 mar!"

(c)(i)

-nterest coverage ratio

"urrent interest coverage ratio B >*555 ;55 B 39 times

-ncreased profit before interest and tax B >*555 x 3.36 B <>.@9m

-ncreased interest payment B (35m x 5.5?) C 5.;m B <3.9m

-nterest coverage ratio after one year B >.@9 3.9 B ;.: times

The current interest co'erage of Droxfol "o is higher than the sector a'erage and can be

regarded as $uiet sa#e. 4ollowing the new loan note issue* however* interest co'erage is

less than hal# o# the sector a'erage* perhaps indicating that Droxfol "o may not #ind it easy

to meet its interest payments.

2 – 3 mar!s"

(c)(ii)

4inancial gearing

This ratio is defined here as prior charge capitale,uity share capital on a boo value basis

"urrent financial gearing B 355 x (;*555 C 6*;55) (;*555 C 66*;55) B 6>8

Irdinary dividend after one year B 5.7; x ;m x 3.59 B <3.@6 million

Total preference dividend B 6*;55 x 5.5? B <66;*555

.ncome statement a#ter one year

<555 <555

'rofit before interest and tax >*@95

-nterest (3*955)

'rofit before tax :*995

Tax (3*?76)

'rofit for the period 9*;5@

'reference dividends 66;

Irdinary dividends 3*@65 (6*59;)Jetained earnings 6*9:7

/inancial gearing a#ter one year B 355 x (3;*555 C 6*;55) (;*555 C 66*;55 C 6*9:7) B 0-

The current #inancial gearing o# *rox#ol Co is less (in relative terms) than the sector

a'erage and a#ter the new loan note issue it is 24 more (in relative terms). This level of

financial gearing may be a cause o# concern #or in'estors and the stoc! mar!et. "ontinued

annual growth o# 12* however* will reduce #inancial gearing o'er time.

2 – 3 mar!s"

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(c)(iii)

=arnings per share

"urrent earnings per share B 355 x (9*;;5 – 66;) ;*555 B @:.; cents

=arnings per share after one year B 355 x (9*;5@ – 66;) ;*555 B @;.> cents

=arnings per share is seen as a ey accounting ratio by investors and the stoc maret* and the

decrease will not be welcomed. However* the decrease is $uiet small and #uture growth in

earnings should $uic!ly eliminate it.

2 – 3 mar!s"

Comment5

3. The analysis indicates that an issue o# new de%t has a negati'e e##ect on the

company+s financial position* at least initially.

6. There are #urther di##iculties in considering a new issue o# de%t. The existing non(

current assets are security #or the existing 1 loan notes and may not a'aila%le

#or securing new de%t* which would then need to be secured on any new noncurrent

assets purchased. These are liely to be lower in value than the new debt and so there

may be insufficient security for a new loan note issue.

7. edemption or re#inancing would also pose a pro%lem* with Droxfol "o needing to

redeem or re#inance 71 million o# de%t a#ter %oth eight years and ten years. Ten

years may therefore be too short a maturity for the new debt issue.

9. n e$uity issue should %e considered and compared to an issue of debt. This could be

in the form of a rights issue or an issue to new e,uity investors.

2 – 3 mar!s"

ACCA +ar!ing Scheme

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Answer 2

(a)

The cost of debt of $ond can be found by linear interpolation.

Gsing 338* the difference between the present value of future cash flows and the ex interest

maret value B (? x ;K@@?) C (355 x 5K7;6) – ?;K5@ B ;7K55 C 7;K65 – ?;K5@ B (<:K@@)

s the net present value is negative* 338 is higher than the cost of debt.

Gsing ?8* the difference between the present value of future cash flows and the ex interest

maret value B (? x :K93@) C (355 x 5K966) – ?;K5@ B ;>K>: C 96K65 – ?;K5@ B <9K@@

s the net present value is positive* ?8 is lower than the cost of debt.

"ost of debt B ? C ((33 – ?) x 9K@@)(9K@@ C :K@@) B ? C 5K@7 B ?K@78 3 mar!s"

Gsing estimates other than 338 and ?8 will give slightly different values of the cost of debt.

(b)

Term structure o# interest rates

ey factor here could be the duration of the bond issues* lined to the term structure of

interest rates.

3. %ormally* the longer the time to maturity of a debt* the higher will %e the interest

rate and the cost of debt.

6. 8ond A has the greater time to maturity and therefore would be expected to ha'e a

higher interest rate and a higher cost o# de%t than 8ond 8* which is the case here.

1 – 2 mar!s"

9i$uidity pre#erence theory

3. Li,uidity preference theory suggests that in'estors re$uire compensation #or

de#erring consumption* i.e. for not having access to their cash in the current period*

and so pro'iders o# de%t #inance re$uire higher compensation #or lending #or

longer periods.6. The premium #or lending #or longer periods also reflects the way that de#ault ris!

increases with time.

1 – 2 mar!s"

Expectations theory

3. =xpectations theory suggests that the shape o# the yield cur'e depends on

expectations as to #uture interest rates.

6. -f the expectation is that #uture interest rates will be higher than current interest

rates* the yield cur'e will slope upwards. -f the expectation is that future interest rates

will be lower than at present* the yield curve will slope downwards.

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1 – 2 mar!s"

+ar!et segmentation theory

3. Maret segmentation theory suggests that #uture interest rates depend on conditions

in di##erent de%t mar!ets* e.g. the shortterm maret* the mediumterm maret and the

longterm maret.

6. The shape o# the yield cur'e therefore depends on the supply o#: and demand #or:

#unds in the mar!et segments.

1 – 2 mar!s"

)ther #actors

3. /ince the two %onds were issued at the same time %y the same company * the

%usiness ris! of DD "o can %e discounted as a reason for the difference between the

two costs of debt. -f the two bonds had been issued %y di##erent companies* a

di##erent %usiness ris! might ha'e %een a reason for the difference in the costs of

debt.

6. The si;e o# the de%t could be a contri%utory #actor* since the 8ond A issue is twice

the si;e o# the 8ond 8 issue . The greater si0e of the $ond issue could be one of the

reasons it has the higher cost o# de%t.

1 – 2 mar!s"

(c)(i)

"ost of e,uity B 9 C (3K6 x (33 – 9)) B 9 C @K9 B 36K98 2 mar!s"

(c)(ii)

Dividend growth rate B 355 x ((;6;5) – 3) B 355 x (3K59 – 3) B 98 per year 1 mar!"

/hare price using DM B (;5 x 3K59)(5K369 – 5K59) B ;65K@9 B :3?c or <:K3? 2 mar!s"

(c)(iii)

%umber of ordinary shares B 6; million

Maret value of e,uity B 6;m x :K3? B <3;9K>; millionMaret value of $ond issue B 65m x ?;K5@355 B <3?K53:m

Maret value of $ond $ issue B 35m x 356K53355 B <35K653m

Maret value of debt B <6?K63>m

Maret value of capital employed B 3;9K>;m C 6?K63>m B <3@7K?:>m

"apital gearing B 355 x 6?K63>3@7K?:> B 3;K?8 2 mar!s"

(c)(iv)

!"" B ((36K9 x 3;9K>;) C (?K@7 x 3?K53:) C (>K@6 x 35K653))3@7K?:> B 33K?8 2 mar!s"

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(d)

*i'idend irrele'ance

3. +iller and +odigliani showed that* in a per#ect capital mar!et* the 'alue o# a

company depended on its in'estment decision alone* and not on its di'idend or

#inancing decisions.

6. -n such a maret* a change in di'idend policy by DD "o would not a##ect its share

price or its mar!et capitalisation. They showed that the 'alue o# a company was

maximised if it in'ested in all pro<ects with a positi'e net present 'alue (its optimal

investment schedule).

7. The company could pay any le'el o# di'idend and i# it had insu##icient #inance*

ma!e up the short#all %y issuing new e$uity. /ince in'estors had per#ect

in#ormation* they were indi##erent %etween di'idends and capital gains.

9. Shareholders who were unhappy with the le'el o# di'idend declared by a company

could gain a homemade dividend+ by selling some o# their shares. This was possi%le

since there are no transaction costs in a per#ect capital mar!et.

3 – mar!s"

*i'idend rele'ance

gainst this view are several arguments for a lin between dividend policy and share prices.

3. 4or example* it has been argued that investors pre#er certain di'idends now rather

than uncertain capital gains in the future (the %ird(in(the(hand+ argument).

6. -t has also been argued that real(world capital mar!ets are not per#ect* but semi

strong form efficient. /ince per#ect in#ormation is there#ore not a'aila%le* it is

possible for in#ormation asymmetry to exist between shareholders and the managers

of a company. *i'idend announcements may gi'e new in#ormation to shareholders

and as a result* in a semistrong form efficient maret* share prices may change.

7. The si;e and direction o# the share price change will depend on the di##erence

%etween the di'idend announcement and the expectations o# shareholders. This is

referred to as the signalling properties of dividends+.

9. -t has been found that shareholders are attracted to particular companies as a result

o# %eing satis#ied %y their di'idend policies. This is referred to as the clientele

e##ect+. company with an established dividend policy is therefore liely to have an

established dividend clientele. The existence o# this di'idend clientele implies that the

share price may change i# there is a change in the di'idend policy of the company*

as shareholders sell their shares in order to reinvest in another company with a more

satisfactory dividend policy. -n a perfect capital maret* the existence of dividend

clienteles is irrelevant* since substituting one company for another will not incur any

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transaction costs. /ince realworld capital marets are not perfect* however* the

existence of dividend clienteles suggests that if DD "o changes its dividend policy* its

share price could be affected.

3 – mar!s"

ACCA +ar!ing Scheme

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Answer 3

(a)

The discount rate should re#lect the systematic ris! of the individual proect being

undertaen. =nless the ris! o# the textile expansion and the di'ersi#ication into the

pacaging industry are the same* their cash flows should not %e discounted at the same

rate.

The discount rate to be used should not be the cost of the actual source of funds for a proect*

but a weighted average of the costs of debt and e,uity which is weighted by the maret values

of debt and e,uity. -t is possible to estimate an existing weighted average cost of capital for

"restlee* but the rate cannot be applied to new proects unless the following assumptions are

compiled with#

(i) The proect is marginal* i.e. it is small relative to the si0e of the company. Taen

together the two proects are not marginal* but this is not a crucial assumption as long

as the costs of debt or e,uity do not alter because of the si0e of the financing re,uired.

(ii) The proect should be financed in a way that does not alter the company+s existing

capital structure. The net present value investment appraisal method cannot handle a

significant change in capital structure.

"restlee+s existing capital structure using maret values is#

<m 8

75 million ordinary shares at 7@5 cents 339.55 ::

<;: million loan stoc at <359 ;@.69 79

3>6.69

-f two investments are considered as a pacage+#

<m 8

%ew finance being raised is# =,uity ?.3>; ::

Debt 9.>6; 79

39.555

The company+s capital structure does not change as a result of these two investments.

(iii) The proect should have the same level of systematic ris as the company+s existing

operations. s the textile investment is an expansion of existing operations it is

reasonable to assume that is has the same systematic ris. The diversification into

pacaging could have very different ris characteristics. The company+s existing

weighted average cost of capital should not be used a discount rate for the

diversification.

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Textile expansion

The discount rate may be based upon the company+s !"" (given that assumptions (iii) and

(iv) are not violated).

Gsing "'M* A e B :8 C (398 – :8) x 3.6 B 3;.:8

!"" B 3;.: 8 x ::355 C 338 x (3 – 5.77) x 79355 B 36.@8

This is the suggested discounted rate for the expansion.

>ac!aging di'ersi#ication

The systematic ris of diversifying into the pacaging industry may be estimated by referring

to the systematic ris of companies within that industry. However* the e,uity beta is

influenced by the level of financial ris (gearing). Gnless the maret weighted gearing of

"anall and /ealalot is the same as "restlee* it is necessary to ungear+ the e,uity beta of these

companies (to remove the effect of financial ris) and regear to tae account of "restlee+s

financial ris.

earing "anall (<m) 8 /ealalot (<m) 8

=,uity >6.5 @3 37@ ?3

Debt 3:.@ 3? 37 ?

@@.@ 3;3

These are both significantly different from "restlee.

Gngearing "anall (assuming debt is ris free and 5=d β )

The asset beta (ungeared) is determined by#

( )

−+= e

d e

e

a

T V V

V

β β )3(

369.3)77.53(@.3:>6

>67.3 =

−×+

×=aβ

Gngearing /ealalot

36?.3)77.53(3737@

[email protected] =

−×+

×=aβ

These are very similar. The ungeared e,uity beta of the pacaging industry will be assumed to

be 3.36;.

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Jegear# solve fore

β using "restlee+s gearing#

)77.53(69.;@339

33936;.3

−×+

×= eβ

;3.3=eβ

A e B :8 C (398 – :8) x 3.;3 B [email protected]@8

!"" B [email protected]@8 x ::355 C 338 x (3 – 5.77) x 79355 B 39.98

3;8 is not an appropriate discount rate for the textile proects. The less risy textile

expansion has an estimated discount rate of 36.@8. The correct discount rate for the proposed

diversification is 39.98 which might be considered to be close enough to 3;8 to ustify the

use of the 3;8 discount rate.

(b)

The mareting director might be correct. -f there is initially a high level of systematic ris in

the pacaging investment before it is certain whether the investment will succeed or fail* it is

logical to discount cash flows for this high ris period at a rate reflecting this ris. Ince it has

been determined whether the proect will be successful* ris may return to a more normal+

level* and the discount rate reduced commensurate with the lower ris. -f the proect fails

there is no ris (the company has a certain failureN)

The other board member is incorrect. -f the same discount rate is used throughout a proect+s

life the discount factor becomes smaller and effectively allows a greater deduction for ris for

more distant cash flows. The total ris adustment is greater the further into the future cash

flows are considered. -t is not necessary to discount more distant cash flows at a higher rate.

Answer

(a)The first error made is to suggest using the cost of e,uity* whether estimated via the

dividend valuation model or the "'M as the discount rate. The company should use

its overall cost of capital* which would normally be a weighted average of the cost of

e,uity and the cost of debt.

Errors speci#ic to CA>+

(i) The formula is wrong. -t wrongly includes the maret return twice. -t should be

)( f m f e R R R K −+= β

(ii) The e,uity beta of 4olten reflects the financial ris resulting from the level of

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gearing in 4olten. -t must be adusted to reflect the level of gearing specific to

!emere. -t is also liely that the beta of an unlisted company is higher than the

beta of an e,uivalent listed company.

(iii) The return re,uired by e,uity holders* i.e. the cost of e,uity* is inclusive of a

return to allow for inflation.

Errors speci#ic to the di'idend 'aluation model

(i) The formula is wrong. -t should be# g P

D+

5

3

(ii) Treatment of inflation – as for "'M.

(iii) gain the impact of the difference in the level of gearing of !emere and 4olten

on the cost of e,uity has not been taen into account.

e'ised estimates o# cost o# capital

4or 4olten

( ) ( )

−+

−+

−+=

d

d e

d

e

d e

e

a

T V V

T V

T V V

V β β β

)3(

)3(

)3(

ssume 955*9*5 == d d V β

= B 3.7@ x 3*@55 x 9 (B share price x no. of e,uity shares) B <?*?7:*555

∴ 5@>.3)7;.53(955*9?7:*?

?7:*?9.3 =

−×+

×=aβ

4or !emere

ssume 955*6*5 == d d V β * e,uity value of <35.: million* debt costs of 378

∴

6;.3

@>6.55@>.3)7;.53(955*6:55*35

:55*355@>.3

=

=

−×+

×=

e

e

e

β

β

β

∴ "ost of e,uity B : C (39 – :) x 3.6; B 3:.58

∴ !"" B 86.9955*6:55*35

955*6)7;.538(35

955*6:55*35

:55*3585.3: =

+

×−+

+

×

*i'idend 'aluation model

4olten

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!e calculate the dividend growth rate#

?.67 x (3 C g)9 B 37.57

g B ?8

87.3?85?37@

8)?3(57.37=+

+×=

e K

!"" B 8?.3:555*37

955*6)7;.538(35

555*37

:55*3587.3? =×−+×

(b)

The estimates of the !"" are significantly different. Gsing the "'M to estimate

the cost of e,uity results in a !"" of 39.68. The use of the dividend valuation

model results in a !"" of 3:.?8. They are both based on estimates from another

company which has* for example* a different level of gearing. The cost of e,uity

derived using the dividend valuation model is based on 4olten+s dividend policy and

share price and not that of !emere. The dividend policy of !emere (e.g. the dividend

growth rate) is liely to be different.

"'M involves estimating the systematic ris of !emere using 4olten. The beta of

4olten is liely to be a reasonable estimate* subect to gearing* of the beta of !emere.

"'M is therefore liely to produce the better estimate of the discount rate to use.

However* this will be incorrect if the proects being appraised have a different level of

systematic ris to the average systematic ris of 4olten+s existing proects or if the

finance used for the proect significantly changes the capital structure of !emere.

(c)

/toc maret efficiency usually refers to the way in which the prices of traded

financial securities reflect relevant information. !hen research indicates that share prices fully and fairly reflect past information* a stoc maret is described as wea

form efficient. -nvestors cannot generate abnormal returns by analysing past

information* such as share price movements in previous time periods* in such a

maret* since research shows that there is no correlation between share price

movements in successive periods of time. /hare prices appear to follow a random

wal+ by responding to new information as it becomes available.

!hen research indicates that share prices fully and fairly reflect public information as

well as past information* a stoc maret is described as semistrong form efficient.

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-nvestors cannot generate abnormal returns by analysing either public information*

such as published company reports* or past information* since research shows that

share prices respond ,uicly and accurately to new information as it becomes publicly

available.

-f research indicates that share prices fully and fairly reflect not only public

information and past information* but private information as well* a stoc maret is

described as strong form efficient. =ven investors with access to insider information

cannot generate abnormal returns in such a maret. Testing for strong form efficiency

is indirect in nature* examining for example the performance of expert analysts such

as fund managers. /toc marets are not held to be strong form efficient.

The significance to a listed company of its shares being traded on a stoc maret

which is found to be semistrong form efficient is that any information relating to the

company is ,uicly and accurately reflected in its share price. Managers will not be

able to deceive the maret by the timing or presentation of new information* such as

annual reports or analysts+ briefings* since the maret processes the information

,uicly and accurately to produce fair prices. Managers should therefore simply

concentrate on maing financial decisions which increase the wealth of shareholders.

'. 3:

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ExAns-Ch16