FINM7402 Tutorial 4: Capital Structure I
Question 1
Assume a world with perfect capital markets and no taxes. HotDog Software has a debt-equity ratio of 0.45. HotDog is paying 7.5% p.a. interest on its outstanding debt. The risk-free rate is 4%. The expected return on the market portfolio is 14% p.a. and HotDog's beta is 1.6.
a) What is the return on equity demanded by HotDog's shareholders?
b) What is HotDog's weighted average cost of capital?
Question 2
Assume perfect capital markets and no taxes. A company begins its existence financed entirely by equity. The required rate of return on this company is 10% p.a. Obviously, the WACC on this all-equity company is also 10% p.a.
a) Several years into its life, the company raises some funds by issuing bonds. Interest payments on these bonds are 6% p.a. After the bond issue, borrowings represent 25% of the total value of the firm.
Calculate the return required by equityholders after the bond issue. Also calculate the firm's new WACC.
b) Assume a further bond issue is made. The interest on debt remains at 6% p.a. Borrowings now represent 40% of the total value of this firm.
Calculate the return required by equityholders after the second bond issue. Also calculate the firm's new WACC.
Commentary:
· From MM, we know that leverage does not affect the total value of a firm or its WACC (assuming perfect capital markets and no taxes). Hence, the WACC will not change in (a) and (b). We have seen this on the graph in lectures where WACC is a flat line.
· The return required by equityholders increases as more debt is issued (equityholders are last in line for annual payments and in the event of liquidation). We have seen this upward-sloping line for on the graph in the lecture, and your calculations in (a) and (b) should confirm this.
Question 3
Assume perfect capital markets and no taxes. Currently ABC Limited is all equity financed. The shareholder’s demand a 12.6% return and the firm’s equity beta is 1.1. The Chief Financial Officer for ABC Limited states: “we should borrow funds and retire some existing equity with the proceeds since this will make shareholders better off”.
a) Show that the shareholder’s return will be enhanced by adopting some leverage. For this purpose assume that the firm is now financed with three parts debt to seven parts equity and that the cost of debt is 6%.
b) Calculate the new equity beta for ABC Limited under this scenario.
c) Does the greater return on equity earned under leverage, as calculated in part (a), mean that shareholders are better off? Use the CAPM to explain why or why not. Assume for this purpose that the market risk premium is 6% and that the debt is riskless.
Question 4
The Motley Corporation, which operates in a perfect capital market, has two financing alternatives for its operating assets that are valued at $1,000,000. These assets are risky and so have an uncertain income generating ability. With equal probability they are expected to earn $100,000 or $200,000 each year. The two financing alternatives are:
i) 100 percent equity: that is there is a million dollars of equity capital
ii) 50 percent debt and 50 percent equity: $500,000 equity capital and $500,000 of bank debt borrowed at 12 percent.
The following table summarises the information:
|
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$
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$
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Earnings before interest
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100,000
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200,000
|
|
|
|
|
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100% Equity
|
|
|
|
Earnings available for distribution to shareholders
|
100,000
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200,000
|
|
|
|
|
|
50% Equity, 50% Debt
|
|
|
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Interest expense
|
60,000
|
60,000
|
|
Earnings available for distribution to shareholders
|
40,000
|
140,000
|
a) Explain what happens to the expected return on equity when we introduce leverage and what is meant by financial risk.
b) Does the firm’s weighted average cost of capital change as leverage is introduced?
c) Explain the reasons for your result in part (b).
Questions 5 – 10 from textbook Chapter 14 of Berk & DeMarzo: 3, 4, 7, 10, 13*, 18*
Question 5 (textbook Chapter 14 Q3)
3. Acort Industries owns assets that will have a 75% probability of having a market value of $48 million one year from now. There is a 25% chance that the assets will be worth only $18 million. The current risk-free rate is 5%, and Acort’s assets have a cost of capital of 10%.
(a) If Acort is unlevered, what is the current market value of its equity?
(b) Suppose instead that Acort has debt with a face value of $18 million due in one year. According to MM, what is the value of Acort’s equity in this case?
(c) What is the expected return of Acort’s equity without leverage? What is the expected return of Acort’s equity with leverage?
(d) What is the lowest possible realized return of Acort’s equity with and without leverage?
Question 6 (textbook Chapter 14 Q4)
4. Wolfrum Technology (WT) has no debt. Its assets will be worth $444 million in one year if the economy is strong, but only $226 million in one year if the economy is weak. Both events are equally likely. The market value today of its assets is $257 million.
(a) What is the expected return of WT stock without leverage?
(b) Suppose the risk-free interest rate is 5%. If WT borrows $52 million today at this rate and uses the proceeds to pay an immediate cash dividend, what will be the market value of its equity just after the dividend is paid, according to MM?
(c) What is the expected return of WT stock after the dividend is paid in part (b)?
Question 7 (textbook Chapter 14 Q7)
7. Cisoft is a highly profitable technology firm that currently has $5 billion in cash. The firm has decided to use this cash to repurchase shares from investors, and it has already announced these plans to investors. Currently, Cisoft is an all-equity firm with 6 billion shares outstanding. These shares currently trade for $20 per share. Cisoft has issued no other securities except for stock options given to its employees. The current market value of these options is $10 billion.
a. What is the market value of Cisoft’s non-cash assets?
b. With perfect capital markets, what is the market value of Cisoft’s equity after the share repurchase? What is the value per share?
Question 8 (textbook Chapter 14 Q10)
10. Explain what is wrong with the following argument: “If a firm issues debt that is risk free, because there is no possibility of default, the risk of the firm’s equity does not change. Therefore, risk-free debt allows the firm to get the benefit of a low cost of capital of debt without raising its cost of capital of equity.”
Question 9 (textbook Chapter 14 Q13)
13. Suppose Visa Inc. (V) has no debt and an equity cost of capital of 9.2%. The average debt-to-value ratio for the credit services industry is 13%. What would its cost of equity be if it took on the average amount of debt for its industry at a cost of debt of 6%?
Question 10 (textbook Chapter 14 Q18)
18. In mid-2015, Qualcomm Inc. had $11 billion in debt, total equity capitalization of $89 billion, and an equity beta of 1.43 (as reported on Yahoo! Finance). Included in Qualcomm’s assets was $21 billion in cash and risk-free securities. Assume that the risk-free rate of interest is 3% and the market risk premium is 4%.
(a) What is Qualcomm’s enterprise value?
(b) What is the beta of Qualcomm’s business assets?
(c) What is Qualcomm’s WACC?