SUGGESTED ANSWERS TO WORKSHOP QUESTIONS

FINANCE & FINANCIAL MANAGEMENT

CAPITAL BUDGETING

QUESTION 1

(a & b)

The NPV of the gift is $1000 independent of the student’s cost of capital. The loan has the
following form:

Year 0 1 2 3 4 5 6 7
------------------------------------------------------------------------------------------------------------
7000 -1000 -1000 -1000 -1000 -1000 -1000 -1000
------------------------------------------------------------------------------------------------------------

The NPV of the loan at different discount rates:

7
1) If R = 0, NPV = 7000 - ∑(1000)/(1+0) =0
t=1
= 7000 - 7000 =0
7
2) If R = 8% NPV = 7000 - ∑(1000)/(1.08)
t=1
= 7000 - (1000)*5.206 =
= 7000 - 5206 = $1794

3) If R = 12% NPV = 7000 - (1000)0*4.564 = $2436

4) If R = 20% NPV = 7000 - (1000)*3.605 = $3395
5) If R = 30% NPV = 7000 - (1000)*2.802 = $4198
6) If R = α NPV = 7000 - (1000)*0 = $7000

PV

loan

$1000 A
gift
0
R
k0 4% k

1
The incremental IRR is:

7
7000 - (1000)*∑{ 1/(1 + Ko) ↙ = 1000
t=1

7
- (1000)*∑{ 1/(1 + Ko) ↙ = -6000
t=1

AF 7/? = 6.000

The critical rate of return is Ko = 4%

ANSWER TO QUESTION 2

(a) When projects are mutually exclusive, the question is not whether to accept or reject
each of them, but rather which of the two projects should be preferred. It has been
shown that even when projects are profitable their rankings may differ. The Ranking
by the NPV depends on the discount rate assumed;
The Ranking by the IRR is invariant to the discount rate.
Therefore the NPV & IRR criteria may lead to different decisions in cases where the
ranking of projects is crucial.

(b) NPVA = 80,000 + (28000)*AF 4/10%

= 80,000 + (28000)*3.170 =
= 80,000 + 88760 = $8760

NPVB = -24000 + (9800)*AF 4/10%

= -24000 + (9800)*3.170 = $7066
4
IRRA = (28000)*∑ { 1/(1 + K) }↙ = 80000
t=1

= AF 4/? = (80000)*/28000
= 2.857 = 15%

4
IRRB = (9800)*∑ { 1/(1 + K)}↙ = 24000
t=1

= AF 4/? = (24000/9600)
= 2.449 = 23%

(c) Project A would be chosen according to the NPV criterion. Object B would be chosen
according to the IRR Criterion.

2
(d) The difference in the ranking between the NPV and IRR stems in this case from the
difference in initial outlays and future cash flows.

For a company with a cost of capital of 10%, it pays to earn a lower rate of return
(15% rather than 23%) on a bigger project, assuming the two alternatives are mutually
exclusive.

The extra outlay and future cash flows implied in the choice of A are desirable for a
firm with a cost of capital of 10%.

(e) The Hypothetical Cashflow ‘A minus B’ can be described as follows:

---------------------------------------------------------------------------------------------------
Year 0 1 2 3 4
---------------------------------------------------------------------------------------------------

A -80000 28000 28000 28000 28000

B -24000 9800 9800 9800 9800
---------------------------------------------------------------------------------------------------
‘A-B’ -56000 18200 18200 18200 18200
---------------------------------------------------------------------------------------------------

The NPV of ‘A-B’ assuming a cost of capital of 10% is:

NPV (A-B) = 18200 * 3.170 - 56000 = 57694 - 56000 = $1694

Internal Rate of Return

4
18200 *∑ { ( 1/( 1 + K)}t = 56000
t=1
AF 4/? = 56000/18200 = 3.077 = 11.4%

Since the NPV of the hypothetical CF ‘A-B’ is positive and its IRR is greater than the
cost of capital, then the project with the lower IRR should be undertaken; and if we
look above to part (c) of the answer, we will see that this decision has been made
according to the NPV rule (and not according to the IRR rule).

Therefore the NPV decision is the right criterion when alternatives are mutually
exclusive.

3
 NPV

12000

16800
15200

A-B 23%
0

11.4% 15%

ANSWER TO QUESTION 3

1) Material Z. 7200 Kilos are required in the first year. The relevant cost is 70,000 kilos
in stock, opportunity cost $99000 plus 200 kilos at $1.46 giving a total cost of
$101,920.
2) Only incremental management salaries are relevant, the TWC new managers plus the
replacement duty manager.
3) The opportunity rental of $120,000 is the relevant cost.
4) Other fixed overhead; the apportionment of rates is not a relevant cost.
5) Apportionment of head office costs is not a relevant cash flow.
6) Interest in monetary terms is ignored as the cost of finance is encompassed within the
discount rate.
7) Year 1 assumes the company has other profits.

CALCULATION OF TAX LIABILITY

(FIGURES IN $000)

Year 1 2 3 4 5
--------------------------------------------------------------------------------------------
Sales 1,320 2,021 2,183 2,355

Direct L 354 553 608 668

Material Z 102 161 174 188
Components
P and Q 250 382 413 445
D Overhead 25 39 42 45
Management S 67 72 77 82
Selling Exp 166 174 183 192
4
 Rental 120 126 132 139
Other Fixed
Overhead 50 53 55 58
--------------------------------------------------------------------------
Total Costs (1,134) (1,560) (1,684) (1,817)

Sales Less
Cash Costs 186 461 499 538

Tax Allowable
Depreciation (213) (213) (213) (213)
--------------------------------------------------------------------------
--------------------------------------------------------------------------
Taxable
Profit (27) 248 286 325
Tax at 35% 9 (87) (100) (114)

CASH FLOW STATEMENT (Figures in $000’s)

Year 0 1 2 3 4
---------------------------------------------------------------------------------------------------

Initial
Investment (864)
Residual Value 12

Sales Less
Cash Costs 186 461 499 538
Tax at 35% 9 (87) (100) (114)
---------------------------------------------------------------------------------
---------------------------------------------------------------------------------
Net Cash
Flows (864) 195 374 399 436

Discount
Factor at 12% 1.00 0.8929 0.7972 0.71118 0.6355
---------------------------------------------------------------------------------
P. Values (864) 174 298 284 277

The NPV = (864) + 1033 = 169

(b) Among the items to which reference could be made are:

(i) Timing of receipts and payments. When will sales made within a year result in
cash receipts? What is the profile of payments during the year? (i.e. are sales
5
 seasonal?). Annual discounting which assumes all cash flows occur at year
ends may be acceptable for illustration but more frequent discounting may be
required in practice.
(ii) Timing of initial expenditure. In reality the actual timing of initial expenditure
and the date of putting the asset to use may alter the point at which tax relief is
obtained and this must be carefully planned and monitored.
(iii) Project’s Life. The possibility of a life in excess of 4 years may be worth
investigating in most cases. However, in the current case the proposal is
justified on a 4 year life and the possibility of a longer life cannot reduce its
present value.
(iv) Variability and sensitivity of estimates. The certainty of figures should be
ascertained and a range of outcomes produced, together with associated
probabilities.
(v) Validity of the high Net Present Value. Assuming use of the 12% discount rate
is valid then this project not only provides an economic return on money but
also provides a high NPV. The economic rationale for this high NPV should
be investigated – the firm may have some competitive advantage or possess
some monopoly it can exploit and so the calculated NPV may be realistic.
However, the apparent high NPV could be the result of bad budgeting or
failure to consider the likely actions of competitors who are also about to enter
an apparently lucrative market.
(vi) Validity of the discount rate. Ascertain whether the company’s 12% required
rate of return is suitable for the degree of risk involved with this proposal.

(c) The various tax incentives to investment, and other tax allowances, can be set against
the firm’s underlying taxable profits. without sufficient taxable profits, or taxable
capacity, the first year allowances will not result in a full tax saving on initial
expenditures with a minimum delay – instead such allowances may have to be
effectively spread over the life of a project thereby loosing some of their present value.
This may make a project unacceptable to a firm with low underlying taxable profits
but the same project acceptable to a company with higher taxable capacity.

Among the possibilities open to a firm which is suffering from a lack of taxable profits
are:

(i) Obtaining taxable profits. Here the firm could consider merging with another
firm with unused taxable capacity – however, the taxation rules should be
carefully scrutinised before this possibility is carried out.
(ii) Leasing rather than buying new assets. The company using the asset will, as
lessee, not be entitled to receive the benefit of capital allowances. The lessor,
as owner, will receive the benefits and will pass these benefits to the lessee in
the form of reduced rentals or in some other form. Hence a firm with small
taxable profits can effectively obtain the benefit of the larger taxable capacity
of the lessor by the process of leasing rather than purchasing.

6
BOND VALUATION

PROBLEM ANSWER 1

The yield-to-maturity of a bond is that interest rate that equates the price of the bond to the
discounted value of the bond’s cash flows.

The general form of the bond valuation equation is:

I1 I2 IN M
Pb    
1  Y 1
1  Y  2
1  Y  N
1  Y N
a. In the case of the first bond, the yield-to-maturity is found by solving the following
equation for Y:

$804.96  $1000.00 /(1  Y ) 3

(1  Y ) 3  $1000.00 / $804.96

1  Y  (1.242)1 / 3

Y  1.075  1  .075  7.5%

b. In the case of the second bond, the yield-to-maturity is found by solving the following
equation for Y:

$60 $60 $60 $1000

$775.40    
1  Y  1
1  Y  2
1  Y  3
1  Y 3
Y must be solved for iteratively. Trying 16% gives:

$775.40  $51.72  $44.59  $38.44  $640.66

 $775.41

Thus, the yield-to-maturity on the second bond is 16%.

7
VALUATION OF EQUITY

QUESTION 1

Rate on
Year Earnings (1-b) Dividend Retention’s Retention’s Pay Off
$m % $m % $m (k)% $m
E (b)
1 6.00 20 1.20 80 4.80 22 1.06
2 7.06 40 2.82 60 4.24 18 0.76
3 7.82 60 4.70 40 3.13 12 0.37
4 8.19 80 6.55 20 1.64 10 0.16

a) go = boko .2 = .8ko ∴ko = 25%

D4 6.56 6.56
b) V3    g = b4k4
R  g .1  .02 .08
R = K4

= $82m

1.20 2.82 4.69 82

c) Vo using Dividend model =  2
 3

1.1 (1.1) (1.1) (1.1) 3
= 1.09 + 2.33 + 3.52 + 61.61
= $68.55m

Vo using earnings model

6
PV of existing earnings = $60.00m
.1

 1.06 
PVGO 1   4.80  (1.1)-1 = 5.27m
 .1 

 .76 
2   4.24  (1.1)-2 = 2.78m
 .1 

 .38 
3   3.13 (1.1)-3 = .50m
 .1 
8.55
68.55

NOTE: stop calculations as R = k

8
 P0 68.55
PE ratio = = =11.42
E1 6

8.55
d) Proportion PVGO = 12.47%
68.55

QUESTION 2

Blaney Engineering

Year Earnings (1-b) Dividend Retention Rate on Retention’s Pay Off

$ % $ % $ (k) $
E (b)
1 500,000 0 0 100 500,000 16 80,000
2 580,000 0 0 100 580,000 16 92,800
3 672,800 0 0 100 672,800 16 107,648
4 780,448 50 390,224 50 390,224 10 39,022

D4 390,224
a) V3    7,804,480 g = k4b4
Rg .1  05

=.1*.5=.05

7,804,408
V0  0  0  0   5,863,621
(1.1) 3

500,000
b) PV of existing earnings  5,000,000
.1
c) PVGO = 5,863,621 – 5,000,000 = 863,621
863,621
 Proportion  14.73%
5,863,621

d) g = bk = (10%)(50%) = 5%

QUESTION 3

Univo plc

a) D0 = $7
D1 after growth of 25% = $8.75
D2 = 10.9375
D3 after growth of 9.5% = 11.98

= Rf +  (Rm – Rf)
9
 = 12+0.82(17 – 12) = 16.1% (use 16%)
g3 = 9.5%

D3 11.98
 P2    $184.31
R  g .16  .095

8.75 10.9375 184.31

 P0     7.54  8.13  136.97
(1.16 (1.16) 2 (1.16) 2

= $152.64

 The shares are overpriced – sell (see below)

b) If interest rates were to increase by 2% the required return on ordinary shares is also
likely to rise, and the share price to fall. If the required return is increased to 2% (in
practice the increase is unlikely to be exactly the same as the interest rate increase), Ke
would move to 18%.

r is increased to 18%

$11.98
 P2   $140.94
.18  .095

8.75 10.9375 140.94

P0     7.42  7.86  101.22
(1.18) (1.18) 2 (1.18) 2

= $116.50

INTRODUCTION TO RISK AND RETURN

ANSWER TO QUESTION 1

12  235  250 100

Return = 
250 1

= -1.2%

ANSWER TO QUESTION 2

(a) R A = 0.25(16) + 0.50(12) + 0.25(8)

= 12%
R B = 6%
R C = 14%
 A = 2.83%
10
  B = 1.41%
 C = 4.24%

(b) COVAB = - 4 where: COVAB = covariance between security A & B

CorAB = -1 CorAB = correlation coefficient between A & B
COVAC = - 6
CorBC = -1
COVAC = 12
CorAC = 1

(c) R AB = 9%
 AB = 0.71%
R BC = 10%
 BC = 1.41%
R AC = 13%
 AC = 3.53%
R ABC = 10.67%
 ABC = 1.89%

RISK-RETURN & CAPM

ANSWER TO QUESTION 1

(a) With the holdings equal, W1 = .5 and W2 = .5. Thus the variance will be:
(.5*.5*20*20) + (.5*.5*20*20) = 200
and the standard deviation (risk) will be the square root of 200 or 14.14.

(b) With a 60-40 mix the variance will be:

(.6*.6*20*20) + (.4*.4*20*20) = 208
and the standard deviation will be the square root of 208 or 14.42.

(c) The 50-50 combination will have the lowest risk. This can be derived formally, but it
can be seen intuitively. Notice that a 40-60 mix would have the same risk as a 60-40
mix and that both have more risk than 50-50 mix.

(a) The 50-50 mix provides the smallest risk, but unless the securities have equal expected
returns, it may not be the best for a given investor, as mixes with more than 50% in the
higher-return security would have greater risk and return. The best portfolio for a
given investor would depend on his or her attitudes towards risk vis-a-vis return.

11
ANSWER TO QUESTION 2

(a) The expected return on the market portfolio is:

E(Rm) = (.333*20) + (.333*-5) = 10%
+(.333*15)

The variance is:

 2(Rm) = (.333*100) + (.333*25) = 116.67
+(.333*225)
The standard deviation is:
 (Rm) = square root of 116.67 = 10.80%

For security A:
E(Ra) = 11.67%
 (Ra) = 15.456%

The covariance of return on A with the market is:

COVam = (.333*10*13.33) + (.333*5*8.33) + (.333*-15*-21.67) = 166.667

While the slope of the capital market line is:

 E ( Rm )  R f 
  = (10 – 7)/10.80 = .2778
  ( Rm ) 

The equation is:

E(Rp) = 7+.2778*  (Rp)

(b) E(Rp) = (.5) (7) + (.5) (10) = 8.5%

 2 (Rp) = (.5)2 (116.667) = 29.167%
 (Rp) = 5.40%

(c) E(Ri) = 7 + (10 – 7)  im = 7 + 3*  im

COVam
(d) a   166.667 / 116.667
 2 ( Rm )
= 1.4286
Since security A’s beta value is greater than one it can be considered aggressive.

(e) The expected return on security A is 11.67; the appropriate return for its beta would
be:
7 + 3*1.4286 = 11.2858
Thus it has positive alpha 11.67 – 11.29, or 0.38%

12
ANSWER TO QUESTION 3

(a) Let W be the fraction invested in the market portfolio, and (1-W) the fraction invested
in the risk free asset.

The expected return on a portfolio is give as

E(Rp) = W*E(Rm) + (1-W)*Rf = 10

16W + (1-W)8 = 10
16W + 8 – 8W = 10
8W = 10 – 8
2
W =  25%
8

 Invest 25% in the market portfolio and 75% in the risk free asset.

The amount of risk in the portfolio depends on how much is invested in the market
portfolio (the risk free asset has zero risk).

The risk of the market portfolio,  m is 12%

 ( R p )  W ( m )  .25(12)  3%

(b) 16W + (1-W)8 = 25

16W + 8 - 8W = 25

17
8W = 25 – 8 = = 2.125 Invested in Rm
8

Invest 2.125 in the market portfolio and –1.125(1-W) in the risk free asset.

For an expected return of 25% one must therefore invest 212.5% of funds in the
market portfolio and –112.5% in the risk free assets. In other words, borrow at the risk
free rate an amount equal to 112.5% of your own funds and invest the total amount
(212.5% of own funds) in the market portfolio.

e.g. Own Funds $1000

Borrow $1125
Invest $2125 in the market portfolio

Expected cash payoff: 16% of $2125 = $340

Less interest on loan: 8% of $1125 = $(90)
$250

$250 represents a 25% return on own funds of $1000.

The risk of the portfolio is:

13
  ( R p )  W ( Rm )  2.125(12)  25.5%

(c) E(Rp)
25% CML

16%

10%
8%

p
3% 12% 25.5%
This is the CAPITAL MARKET LINE

ANSWER TO QUESTION 4

12  5
Slope of capital market line   1.75
4

i.e. market risk premium gives extra return of 1.75% per unit of standard deviation.
Consider portfolios and extra return per unit of standard deviation:

A=1.75 – Efficient
B=1.67 – Inefficient, σ should be 11.4%
C=1.83 – Super-efficient
D=1.6875 – Inefficient, σ should be 15.4%
E=1.75 – Efficient
F=1.5 – Inefficient, σ should be 1.71%

14
ANSWER TO QUESTION 5

If A with a beta of 0.5 has a risk premium of 4%, then B will have a risk of premium of 1.75 x
4
 8% , as the expected return of B is 20% the risk free rate must be 6% and the expected
0.5
market return 14%.

The returns required from betas given are:

Security Beta Return

1 2.00 22 Overpriced
2 0.75 12 Underpriced
3 1.25 16 Overpriced
4 -0.25 4 Underpriced
5 3.25 32 Overpriced

COST OF DEBT & EQUITY AND WEIGHTED AVERAGE COST OF CAPITAL

Answer to Question 1

(a) WACC: Use Gordon Growth model to calculate required return on equity:

D1
Ke  g
V0

Growth is calculated by examining growth in dividend payments over the past four
years which has been approximately 10% p.a.:

10.25(1.1)
Ke   0.1
113

= 0.1997 (20%)

Required return on debentures (incorporate tax benefit):

10(1  0.5)
Kd 
62.5

= 0.08 (8%)

 4520   625 
WACC  0.20   0.08 
 5145   5145 

= 0.1757 + 0.0097
= 0.1854 (18.54%)

15
 Note that market values are used to calculate the weights for each source of finance for
the estimation of the WACC.

(b) If we assume that the market risk premium ( R m – Rf) is 9%, then cost of capital can be
calculated using CAPM as follows:

Ke = 0.12 + 1.2(0.09)
= 0.228(22.8%)

E D
(c)  Asset   Equity   Debt
ED DE
On the assumption that  debt → 0:

 4520 
 1.2 
 5145 

= 1.05

Kp = 0.12 + 1.05(0.09)

= 0.2145 (21.45%)
or allowing for corporate taxation:

 D 
 Levered   Unlevered 1 
(1  T ) 
 E 
 625 
1.2 =  u 1  (1  0.50) 
 5145 

 u = 1.13

and:

Kp = 0.12 + 1.13(0.09)
= 0.2217 (22.17%)

(d) The results obtained range from 18.54% using WACC to 22.17% obtained using an
appropriate asset beta.

Use of the Gordon growth model is very sensitive to the value assigned to growth. In
this case, it is based on the average growth for the past four years; however, research
has shown that past growth is no predictor of future growth and care needs to be
exercised in interpreting this figure.

16
 The cost of capital using CAPM was based on an historic equity beta (i.e. calculated
using observed past returns), whereas the theory is based on expected returns. The
stability of individual betas is suspect and it might be wise to use an average beta of
companies undertaking similar activities to that being appraised. In addition, a market
risk premium of 9% has been assumed which is based on historic average-risk
premiums. Is it appropriate to use this or should average-risk premiums be expected to
vary over time?

Answer to Question 2

(a) Cost of equity capital using Gordon growth model:

D1
Ke  g
P0
where:

Ke = cost of equity;
D1 = dividend expected one year from now;
g = expected future growth in dividend payments;
P0 = current ex div. market price of shares

Given that D1 = 10(1 + g) and that g must be estimated from information given, and
suggesting that last three years’ average growth (10%) be taken as average for
previous ten years to reflect effects of dividend controls, then:

10(1  0.1)
Ke   0.1
100

= 0.21 (21%)

Cost of equity capital using CAPM:

Ke = Rf + βE( R m – Rf)

where:

Ke = expected return on equity;

Rf = risk-free rate of interest;
R m = expected return on market;
Cov E , M
βE = beta of equity =
VM

and:

Cov E ,M  expected covariance between share and market returns;

VM = variance of market returns
17
 then:

0.275
E 
(0.5) 2

= 1.1 (using future expected covariance)

and:

Ke = 0.05 + 1.1(0.15 – 0.05)

= 0.16 (16%)

(b) The two methods give significantly different results: the growth model 21%, CAPM
16%. This may be because of the different approaches. The growth model is
historically based using past growth as an indicator of future growth. As the model is
very sensitive to the value placed on growth, this can be a drawback to its use,
particularly as evidence suggests that growth in earnings and hence dividends does not
follow a regular pattern. Also past growth is no indicator of future growth.

CAPM is an ex ante theory looking at expectations about the future. The expected
market return and covariance have therefore been used. Use of CAPM assumes that
all investors hold well-diversified portfolios and therefore the only risk rewarded will
be market or systematic risk; unsystematic or specific risk is diversified away by
holding a portfolio. In this case, use of the model depends crucially on the estimate of
expected market return and covariance. However, the market risk premium (expected
market return minus risk-free rate) of 10% compares favourably with average historic
risk premiums which have been estimated at about 9%

(c) Changes in expected rates of inflation will affect a company’s cost of capital. Interest
rates are generally assumed to reflect expected inflation and the nominal or monetary
rate can be expressed as follows:

(1 + n) = (1 + r)(1 + I)
n = r + i + ri

Nominal = real + inflation + cross product

Thus if expected inflation was to increase, then the cost of capital could be expected to
rise. Increasing inflation could also add to the perceived riskiness of the company and
could lead to higher-risk premium being demanded for investment in the company.

It should be noted that increased inflation per se would not necessarily lead to an
increase in cost of capital; it is changes in expectations which should fuel changes in
required returns.

18
Answer to Question 3

(a) Using data given, 16 = 10 + βE(15 – 10)

βE = 1.2

At present βE = βA with new capital structure

E
1.2  (t  0.50)
1
1  (1  t )
2

βE = 1.5

Revised return on equity

= 10 + 1.5(15 – 10)

= 17.5%

Risk of equity increases as debt is added to capital structure; this is mitigated to some
extent by the tax deductibility of debt interest.

 2 1
(b) WACC  17.5   5 
 3   3

= 13.3%

We need to assume that all projects appraised have the same level of risk as average
risk of projects currently being undertaken; that the company is at its target level of
gearing and any new project will be financed by the same mix of debt and equity; and
that all cash flows are perpetual as is debt.

The assumptions on which the weighted average cost of capital (WACC) is used as an
NPV discount rate are as follows:

(i) The financing of the project, if accepted, will not change the company’s
existing financing mix.
A change in the company’s capital structure would be expected to change its
WACC. Changing the gearing ratio will change the amount of financial risk
borne by ordinary shareholders and hence will change the ‘cost of equity
capital’ value in the WACC calculation and also, changing the gearing will
change the weights (assuming market value weights) used in the WACC
calculation.

(ii) The project should be marginal, i.e. it is small relative to the size of the
company. The WACC is a marginal rate of return. The WACC is made up of
the ‘cost’ of each individual source of the company’s capital, and each of these
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 costs represents the required return on a marginal investment in that security,
(see part a).

(iii) Level perpetuity cash flows. This arises from the fact that the WACC
calculation is a level perpetuity model. The different types of company capital
should therefore involve only level perpetuity cash flows.

(iv) A constant level of risk. A company’s WACC represents the overall return
that the company earns, given a particular level of risk. Its WACC is therefore
applicable only to the evaluation of new investment opportunities that have a
similar level of risk.

(c)
There are a number of practical problems which may be encountered in the calculation of
WACCs. The principal ones being as follows:-

(i) The complexity of capital structures

In the real world, structures may be very complex, e.g. the inclusion of
convertible loan stock or the use of the bank overdraft as a long-term source of
funds.

(ii) The calculation of the cost of equity (Ke) capital relies on estimates of the
market value (p) of the equity and of the future dividends growth rate (g).
Share prices which are volatile present a problem in deciding upon which
market price to use and dividend growth rates may fluctuate with great
regularity. Various models which have been developed such as the Gordon
Model are very limited in their usefulness because they rely on a number of
assumptions which do not always hold good in the real world. Another method
of calculating the cost of equity (Ke) capital would be to use the capital asset
pricing model (CAPM) but this also has its difficulties, e.g. the specification of
the risk-free interest rate.

(iii) Taxation. The tax system relating to companies is now so complex that it is
very difficult to compute a reliable after-tax WACC.

To compute a company’s weighted average cost of capital it is necessary to

estimate the after-tax market return and market capitalization (or equivalent)
for each type of long-term capital.

Bank overdrafts in the financial structure do not cause much difficulty as long
as the amount of the overdraft remains reasonably stable. The interest rate
charged on the overdraft can be expected to vary with changes in market
interest rates and so the current ‘market value’ of the overdraft will remain
equal to its nominal amount. Furthermore, given that the overdraft is repaid at
par, the after-tax market return will simply be the current actual overdraft
interest rate, adjusted for the tax relief on the interest payments.

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 Convertible loan stock however, does present problems. It may well have a
market quotation and in such circumstances, finding its capitalized market
value causes no problems. On the other hand if it is unquoted an equivalent
valuation must be estimated. The valuation of convertible loan stock can be
found by splitting it into its two elements: the loan stock itself and the
convertible option. Thus its market value can be estimated at the greater of its
value as a simple loan stock or its value if converted immediately, plus the
value of the call option.

However, apart from these difficulties, whether or not a market value exists,
there is still the problem of estimating the market return on the security which
depends upon the point in time at which conversion is expected to take place
and the gain expected by the stockholders on conversion.

Answer to Question 4

(a) After-tax WACC for each capital structure:

After tax cost of debt = 50% x 10% = 5%

Gearing ratio WACC

0% = 20%
20% (0.2 x 5%) + (0.8 x 21.25%) = 18%
40% (0.4 x 5%) + (0.6 x 23.333%) = 16%
50% (0.5 x 5%) + (0.5 x 25%) = 15%
60% (0.6 x 5%) + (0.4 x 27.5% = 14%

Total market capitalisation of firm:

In each case this is:

Annual earnings before tax x (1 – tax rate)

WACC

as follows:
Gearing ration Market capitalization $ million
0% 12.6 x (1-0.5)  0.2 = 31.5
20% 12.6 x (1-0.5)  0.18 = 35.0
40% 12.6 x (1-0.5)  0.16 = 39.375
50% 12.6 x (1-0.5)  0.15 = 42.0
60% 12.6 x (1-0.5)  0.14 = 45.0

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FOREIGN EXCHANGE RISK

Suggested to Sebest Question

The value of the exposure is £1,809,466. This is the amount that needs to be covered. Sebest
has about S$4,625,000 at risk. The value of the exposure at today’s spot rate of 2.5560/£.

Forward Market

Sell £ 6 months forward £1,809,468 at 2.521 = S$ 4,461,669

This gives $63,331 less than the actual value of the transaction at today’s spot rate.

Money Market

 £1,809,468 
Borrow    £1,744,066
 1.0375 
Convert the borrowed amount £1,744,066 at the spot rate of 2.556 = S$4,457,832
The borrowed amount should be invested in S$ for 6 months. This is shown below:

4,457,832*1.015 = S$4,524,699

The above amount is lower than the forward cover by S$36,970 and the company is worse off
by S$100,301 than the present value of the transaction at today’s spot rate.

Options

The options are $ options. The company should consider buying March call option contracts.

The 2.525 contract may be ignored as it does not produce enough S$.

The number of contracts that the company should buy is 37.

Exercise price of S$2.550: The Company needs the following amount to fulfil its contract (if
option is exercised):

 $4625000 
   £1,813,725
 2.55 

The company is expected to receive £1,809,468. Thus, it needs £4257 6 months forward to
exercise the contract (or buy spot at an unknown rate). The cost is £4257*2.5270 = S$10,757

Premium = 1,813,725*3.2 cents = S$58,039

Overall S$ to be received if the option is exercised (i.e if spot rate is lower than S$2.55/£)

4,625,000 – 10,757 – 58,039 = S$ 4,556,204

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This is S$68,796 less than the value of the transaction at today’s spot rate.

But if the spot is higher than 2.55 the option is not exercised.

At 2.575 exercise price, the company still needs 37 contracts. 37 is still the nearest.

 4,625,000 
   £1,796,117
 2.575 

The company is expecting to receive £1,809,468. The receipts will $13,351 over the required
amount if the option is exercised. The excess cash flow could be sold 6 months forward at
$2.521/£ = $33,659

Premium is £1,796,117*6.3 cents = $113,155

Overall $ = 4,625,000 + 33,659 – 113,155 = S$4,545,504. This amount is $79,456 less than
the value of the transaction at today’s spot rate. This would reduce if $ value is higher than
$2.575

Overall no method can guarantee receipts of $4,625,000 (excluding transaction costs).

Forward contract has the lowest difference from spot value. The 2.550 option is $5,465 worse,
but allows for gains if £ strengthens against the S$. Choice should be between these –
probably favouring currency options.

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