Corrected Assignment FM

8/3/2019 Corrected Assignment FM

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PART-A

(a)

Brown's debt ratio before afterthe capital restructuring

=

* 100

= 39.93%

Brown's debt ratio before afterthe capital restructuring

=

*100

= 42.35%


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(b)

Brown's WACC before capital structure

Cost of debt = (1-T) R * 100

=(1-.4) * .06 * 100

= 3.6%

Cost ofordinaryshare = 11%

Cost ofretained earning = ( .11 *

)

= 7.10%

Source of fund Book value Market value Proportionofeach element

Cost of eachelement

WACC

6% Debt 600000 600000 .39 .036 0.01404

Ordinaryshare 500000 850000 .56 .11 .0616

Retainedearning

75000 75000 .05 .071 .00355

1525000 1.00 .07919

7.9%WACC before re-structure


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Brown's WACC before capital structure

Source of fund Book value Market value Proportionofeach element

Cost of eachelement

WACC

6% Debt 600000 600000 .28 .036 0.01008

Ordinaryshare 500000 1450000 .68 .11 .0748

Retainedearning

75000 75000 .04 .071 .00284

2125000 1.00 .08772

8.78 %

(c)

I will use the cost of debt 3.6% as a discount rate because it is the lowest among all other discountrate including cost of equity,retained earning and WACC. Ifwe invest 700000 and re-structure our

capital,we can invest it byselling debenture as a rate of 6 %.

Kd = 3.6% < Ke= 11%, Kr= 7.10%, WACC = 8.78 %

WACC after re-structure

Re- investment of 700000


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PART-B

Step-1 : Calculation of net cash outlay

= 3905000 + 60000 6000

= 3959000

Total cost of the equipment :

Equipment cost 3500000

Software development ( 75000 * 3) 225000

Alterationof manufacturing line 180000

3905000

Cash inflow from old machine

Particulars 1styear 2

ndyear

Acquition cost 170000 305000

Accumulated dep. 100000 215000

Booksalvage value 70000 90000

Calculation of Net present value & Internal

rate of return

Total cost of the equipment + working capital tied up Cash inflow from old machine


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Cash salvage value 30000 140000

result Loss ( 40000) Profit ( 50000)

Difference 10000 ( profit)

After tax cash inflow from old machine = (1-.40) 10000

= 60000

Step-2 : calculation of annual depreciation

Depreciation =

=

= 547143

Step-3 : calculation of Net cash benefit

particulars 1st

year 2nd

year 3rd

year 4th

year 5th

year 6th

year 7th

year

Revenue 0 1200000 1200000 1200000 1200000 1200000 1200000

(-) operatingincome

Computeroperatorsalary

120400 120400 120400 120400 120400 120400 120400

Maintenancetechnical

125000 125000 125000 125000 125000 125000 125000

Gross Margin (245400) 954600 954600 954600 954600 954600 954600

(-)

administrativeexpenses

Training 35000 25000 10000

Depreciation 547143 547143 547143 547143 547143 547143 547143

EBIT (827543) 382457 954600 954600 954600 954600 954600

(-)interest 0 0 0 0 0 0 0


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EBT (827543) 382457 954600 954600 954600 954600 954600

(-) tax 40 % 152983 158943 162983 162983 162983 162983

NIAT (827543) 229474 238474 244474 244474 244474 244474

(+) non cashcharges

547143 547143 547143 547143 547143 547143 547143

NCB (280400) 776617 785617 791617 791617 791617 791617

Step-4: calculation of Excess cash flow from equipment & spare parts (7th year)

Excess cash flow from equipment

Booksalvage value 75000

Cash salvage value 0

(75000)

Tax savings = 75000 * .30 = 22500

Excess cash flow from equipment

Booksalvage value 60000

Cash salvage value 60000

Nil

Total = 60000 + 22500

= 82500

Net cash inflow for 7 years


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Period NCO

0 (3959000)

1 (280400)

2 776617

3 7856174 791617

5 791617

6 791617

7 791617

7 82500

Period NCB Present valuefactor6%

Present valueamount

0 (3959000) 1.00 (3959000)

1 (280400) .943 (264417)

2 776617 .890 691189

3 785617 .840 659918

4-7 791617 5.582 43350767 82500 .665 54863

1517629

NPV is positive thatswhy the equipment can be bought

Calculation of net present value


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IRR = UL

%

= 17 % -

%

= 17% - 0.034%

= 16. 97 %

IRR is more than the npv present value. thatswhy the equipment can be bought

Period NCB Present valuefactor17%

Present valueamount

0 (3959000) 1.00 (3959000)

1 (280400) .855 (239742)

2 776617 .731 567707

3 785617 .624 490225

4-7 791617 3.922 3104722

7 82500 .333 27473

(8615)

Calculation of IRR


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PART-C

Modigliani- Miller theorem

Definition :

A financial theorystating that the market value of a firm is determined by its earning powerand

the riskof itsunderlying assets, and is independent of the way it chooses to finance its investmentsor

distribute dividends. Remember, a firm can choose between three methodsof financing: issuingshares,

borrowing or spending profits (as opposed to dispersing them to shareholders in dividends). The

theorem gets much more complicated, but the basic idea is that,under certain assumptions, it makesno

difference whethera firm finances itselfwith debt orequity.

Theory, a form of modern thinking to capital structure :

y Traditional theory: if a firm substitutes debt forequity, it will reduce its cost of capital so increasingthe firms value:

r rD

D Er

E

D Er r r

D

D Ea d e e e d

!

!

.

y But, when the D/E ratio is considered too high, both equity-holders and debt-holders will startdemanding higher returns so that the cost of capital of the firm will rise. Hence, There exists an

optimal, cost minimizing value of theD/Eratio.

average cost of

capital

debt/equityratio

M-MM-M


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y Modigliani- Miller (M-M) proposition 1:The value of a firm is the same regardless of whether itfinances itself with debtor equity.The weighted average costof capital: ra is constant.

Assumptions of M-M: perfect and frictionless markets,no transaction costs,no default risk,no taxation,

both firms and investors can borrow at the same rd interest rate.

y Ex. Consider two firms: one has no debt while the other is leveraged (i.e. has debts). They areidentical in everyotherres pect. In particular they have the same level ofoperating profits: X. Let Ahave 1000 shares issued at 1 euro and B have issued 500 (1 euro) shares and 500 euroof debt.

Firm A Firm B

Equity E 1000 500

Debt D 0 500

y 100 sharesofB (1/5EB) give right toreceive a return:

R X r Dd

! 1

5

1

5

y 200 sharesofA (1/5EA) bought using 100 euroof borrowed money (100=1/5DB) give the same return:

R X r Dd

! 1

5

1

5.

y The two investmentsyield the same return (and have the same financial risk) Hence 1/5 ofA musthave the same value of 1/5 ofB: both sharesshould be equally priced. Ifnot, arbitrageurswill have

profitable operations at theirdisposal.


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Firm A Firm B

Possible

equilibrium

Firm A

Possible

equilibrium Firm

B

Operating profits X 10.000 10.000 10.000 10.000

Interests rdD 3.600 3.600

Profitsofshares X-rdD 10.000 6.400 10.000 6400

Shares market value E 66.667 40.000 68.000 38.000

Returnon equity re 15% 16% 14,7% 16,8%

Market value of debt D 30.000 30.000

Market value of firm V 66.667 70.000 68.000 68.000

Av. cost of capital ra 15% 14,3% 14,7% 14,7%

Debt ratio D/E 0% 75% 0% 78,9%

y FirmB isovervalued with respect toA. Anoperatorowning 1% ofB can:1.sellhissharesofB fora market value of 400;2. borrow 300 (i.e. 1% of the debt ofB) at rd= 12%3. buy 1% ofA fora value of 667.

y He then owns 1% of the unleveraged firm but has a debt equal to 1% of that ofB. His risk is

unchanged. Before he had an expected returnof 64 (=0.16400). Now he still have a returnof 64 (he

expects toreceive 100 = 0.15667 but he has to pay 36 as interests). But: before he had invested 400

of his money,nowonly 367=667300

y Hence it is profitable tosell B (the overvalued shares) and buyA (the undervalued ones). The price of

A rises and that ofB falls. The table shows a possible positionof equilibrium: ra is the same as it

should be since, by hypothesis,A and B have the same degree ofrisk. By contrast,re is higher for Bbecause itsglobal risk,which is equal to that ofA, has to be shared by a lowervalue of equity.


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y M-M proposition 2:the rate of return on equity grows linearly withthe debtratio.

From: rX

E Da

!

and rX r D

Ee

d!

it follows that: r E r E D r De a d! and hence that:

r r r r D

Ee a a d

!

y

M-M proposition 3:the distribution of dividends does not c

hange t

he firms market value: it onlychanges the mix ofEandD in the financingof the firm.

y M-M proposition 4:in orderto decide an investment, a firm should expecta rate of return at leastequalto ra,no matter where the finance would come from. This means that the marginal cost of capitalshould be equal to the average one. The constant ra is sometimes called the hurdle rate (the rate

required forcapital investment).

Example: Let ra = 10%. The return expected from an investment is 8% and it can be financed by

borrowing at 4%. The firm should not actuate this project. To see why, assume that the firm is

unleveraged, its expected operating profits are 1,000so that its market value is10,000 = 1,000/0.1. Theinvestment project is for100. If it is actuated, the firmsoperating profitswould be 1,008 and its market

value 10,080. But the firms equitywould be worth only9,980 because the value of the debt has to be

subtracted.


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Critique of the M-M theory by showing advantages &

disadvantages

y The M-M propositions are benchmarks,not end results: financing doesnot matterexcept formarket

imperfectionsorforcosts (f.e. taxes) not explicitly considered. A hint that financing can mattercomesfrom the continuous introduction of financial innovations. If the new financial products neverincreased the firms value, then there would be no incentive to innovate.

y Non-uniqueness of ra: perhaps it isnot very important.

y Taxation: since interests are considered as costs, a leveraged firm has a fiscal benefit. Itsoperatingearningsnet of taxes are:

X t X r D r D t X t r Dn c d d c c d! ! 1 1

while for anunleveraged firm they are: X t X

n c! !1

net profits. The difference:

t r Dc d

, once capitalized at ra, makes the value of the leveraged firm greater than that of the

unleveraged by the amount:

t r D

r

c d

a

. At the limit: the optimal capital structure might be all debt

(Miller). But it isnecessary to consider the personal taxationof capital gains, dividends and interests that

can (partially) offset the firms tax advantages. In the absence of offsetting,nothingwould sto p firms

from increasing debt in order to decrease taxation. There must be some costs to prevent aggressive

borrowing.

Footnote:

Fiscal shield: Drt dc

I have capitalized it at ar

According tootherscholars, ifyou assume that:

1. the firm expects togenerate profits2. the cash flows are considered to be perpetual


14/23

>>the difference between the cash flowsof the leveraged firm and that of the unleveraged firm has the

same risk ofthe intereston debt.

>>hence you can capitalize the fiscal shield at dr so that:

DtVV cuL !

Instead of: Dr

rtVV

a

dcuL !

In any case:

But, is it correct to have anunlimited increase in LV ? It doesnot seem so.

Fiscal shield

D

VL

VU


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The present value of the distress costsreduce the present value of the fiscal shield.

y Risk of defaultor of financial distress: both the firm and the lenders may considernew debt toorisky.According to the trade-off theory, firmsseekdebt levels that balance the tax advantage of an increase

of debt with the prospective costsof possible financial distress. It so predicts moderate amount of debtasoptimal. But there is evidence that the most profitable firms in an industry tend to borrow the least,while theirprobabilityof entering in financial distressseems to be very low. This fact contradicts thetheory because, if the distressrisk is low, an increase of debt has a favourable (and almost riskless) taxeffect.

y Asymmetric information and agency problems. Financial policy acts as a signal forthe markets:1. A high leverage tends to improve the efficiencyof the managers. So investors tend to consider the

issue ofnew debt in a favourable way (up to a limit,of course).2. But, aswe shall see lateron, the managers may decide to actuate riskierprojects. To try to avoid this

outcome, the equity holders favours bankindebtment because they thinkthat the banks have powerfulmeans to control the managers. Bank can in fact threaten the managers with the request of debts

repayment.3. Managers could consider the issue of new shares. But they could also consider the risk of being

overthrown. Still more important is the risk coming from the possible market reactions. In fact, thewould-be stock investors tend to think that the managers, acting in the interest of existing

stockholders,would never issue newshares at anundervalued price. Theywould instead try tosell the

stockat anovervalued price. Hence the market would react in anunfavourable way, i.e. by marking-down the stockprice. The managers then prefernot to issue newshares even if this decisions has theeffect ofrejectingsome profitable investment programs.

4. Hence the form of finance the managers mostly prefer is undistributed profits. But they have toconsider that it is difficult to cut dividends inorder to have more internal finance. In all likelihood, themarket would react badly. In fact, an announcement of lower dividends is considered by investors as

VL

VU

D

Present value of distress costs

Fiscal shield


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an information that the firm isnot ingood health: the market value of the firm declines (the conversehappenswhen there is an announcement ofgreaterdividends).

5. The pecking order theoryrecognize that the internal resources and the external ones are not perfectsubstitutes in a world of asymmetric information between investors and managers. The formers askfora premium inorder to be compensated for the risk that the informationgiven them by managers isnotquite candid. The required premium is higher for the equity investors and lower for the debt investors.

The theory then maintains that the formsof finance preferred by managers have a definite order: 1.Undistributed profits; 2. Debt; 3. Equity. This fact has a relevant impact on the firms investmentdecisions: insufficient internal resources and difficulties in obtaining bank loans may result in thecurtailment of investments, in particularthose of the small and medium size firms.

6. Conflict s between debtholders and stockholders: only arise when there is a risk of default or offinancial distress. In the absence of this risk, debtholders have no interest in the firms value. But,when the riskissignificant, they have to considerall the costs that would reduce the value of the debt:

costsof lawyers and accountants,judiciary expenses, costsof the financial expertsof the court, and so

on;

lossofreputation and customers.

There are alsoAgency costs:when a firm has high debts, the shareholders have:

1.incentives to undertake riskier projects, evenwith the consequence ofreducing the expected value of

the firm. Example: Assume that the probabilityof both boom and depression is and

low risk high risk

Firms value Stock Debt Firms value Stock Debt

Depress. 400 0 400 200 0 200

Boom 800 400 400 960 560 400

Exp. Val 600 200 400 580 280 300

2.incentives to underinvest(debt overhang) as the foll. ex. shows.

Ex.: Considera firm with a debt of 2000 that will default in the case of depression. It has an investment

project that with an expenditure of 600 would forsure increase itsoperating profits by 900. The firms

expected profits X are shown in the following table, both with the investment actuated and without it:

State of the world X without I X with I


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Boom 2500 3400

Depression 1200 2100

Expected value 1850 2750

Note that: (E X I ! !900 600 300 . The value of the firmwould be increased by the investment. But:

State of without I without I with I with I

the world D E D E

Boom 2000 500 2000 1400

Depression 1200 0 2000 100

Exp. value 1600 250 2000 750

Note that: E E I( ! 500 600 so that the expected value of the equitywould be decreased by the considered investment.

y Hence, the existence of the conflict of interests means that the mere threatof default can influence afirms investment decisions in anunfavourable way. Since investorsunderstand thisrisk, the marketprice of both the debt and the stock decline. This is anothergood reason for managers tooperate atrelatively low debt ratios.

y Conflicts between managers and stockholders. The latterfavourdebt because, by forcing the managersto pay interest, force them to avoid inefficiencies, overinvestment and excessive utilization of thefirms resources to the managers benefit. The free cash flow theory that maintains that high debtratios increase firms value,notwithstanding the threat of financial distress, isuseful to explain thebehaviourof mature (cash-cow) firms that are prone tooverinvest.


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PART-D

(a) Cost of long-term debt, first $550 000 =

=

* 100 * (1-.40)

= 5.6 %

(b) Cost of long-term debt,greaterthan $550 000 =

* (1-t) * 100

=

*(1-.40) * 100

= 8.13 %

(c) Cost ofpreference share =

=

* 100

= 19 %

(d) Cost of ordinaryshare first 1.75 million =(

+ growth rate ) * 100

=(

+ G)

= (

+ .115)

= 19 %


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(e) Cost of ordinaryshare greaterthan 1.75 million =(

* 100

=(

+ .115) * 100

= 22 %

(f) Ranges of total new financing over which the firm's WACC remains constantbreak points associated with each source of capital and

To find where a break in the marginal cost of capital schedule occurs, we just need to know two

pieces of information: the weight of debt and the maximum amount of debts that can be sold at

5.6%. Here,

Weight of debt = 35 %

maximum amount of debts that can be sold at 5.6% = 550000

If 35% of the funds will be debt and the firm can raise up to 550000 at 5.6%, then how much

total funds from all sources can be raised without having to issue the more expensive 8.13 %debt? .35 of X has got to be less than or equal to $550000. So, if .35X


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(g) WACC over each of the ranges of total new financing of F

Name ofsources Amount weights Cost of capital WACC

Long term debt 280000 .35 0.056 0.0196

Preference share 120000 .15 .19 0.0285

Ordinaryshare 400000 .50 .22 0.11

0.1581

WACC = 16 %

(h)Graphical idea of the G firm's weighted marginal cost of capital (WMCC) and IOSWACC(B, C , D , F , G)


Long term debt 280000 .35 0.056 0.0196


Ordinaryshare 400000 .50 .22 0.110.1581

WACC = 16 %

WACC(A, E )


Long term debt 280000 .35 0.056 0.0196


Ordinaryshare 400000 .50 .19 0.095

0.1431

WACC = 14 %


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0%

5%

10%

15%

20%

25%

30%

A B C D E F G

IRR

WACC

X axis = Investment schedule opportunity

Y axis = IRR & WACC


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(i) Recommended investment :

Project IRR Initial Investment WACC

A 14% $300,000 14 %

B 25% $400,000 16 %

C 17% $600,000 16 %

D 14% $500,000 16 %

E 19% $300,000 14 %

F 16% $800,000 16 %

G 15% $400,000 16 %

Explanation :

Here,we should choose B. Because in proposal ofB IRR is highest than A,C, D, E, F, G. Also,

the WACC isonly 16 % which is also the minimum cost of capital. So, ifwe go for the proposal B,we

will be benefited byourhighest IRR 25 % & the cost of capital 16 %


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1. Advanced Corporate Finance

y Krishnamurti & Viswanath

2. Advanced Management Accounting

y Kaplan & Atkinson

3. Budgeting: Profit Planning and Controly Welsch, Hilton & Gordon

4. Principles of Corporate Finance

y Brealey, Richard A.; Myers, Stewart C

5. "The weighted average cost of capital, perfect capital markets and project life: a clarification"

y Miles, J.; Ezzell, J. (1980)

6. en.wikipedia.org/wiki/Financial_management

7. www.investopedia.com/terms/c/ costofcapital.asp

8. www.morevalue.com/i-reader/ftp/Ch13.PDF

Bibliography

Corrected Assignment FM

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