Strategic Finance

MBA

Practice questions: Financing Decisions

Question 1
As a financial analyst of a large electronics company, you are required to determine the weighted average cost
of capital of the company using (i) book value weights and (ii) market value weights. The following
information is available for your perusal:

The company’s present book value capital structure is: Rs.

Preference shares (Rs. 100 per share) 200,000
Equity shares (Rs. 10 per share) 1,000,000
Debentures (Rs. 100 per debenture) 800,000

All these securities are traded in the capital market. Recent prices are:

Debentures @ Rs. 110 per debenture

Preference shares @ Rs. 120 per share
Equity shares @ Rs. 22 per share

Anticipated external financing opportunities are:

i) Rs. 100 per debenture redeemable at par; 10 year-maturity, 13% coupon rate, sale price Rs. 100.
ii) Rs. 100 preference;10 year-maturity, 14% dividend rate, 5% flotation costs, sale price Rs. 100.
iii) Equity shares: Rs. 2 per share flotation costs, sale price @ Rs. 22.In addition, the dividend expected on the
equity share at the end of the year is Rs. 2 and the earnings are expected to increase by 7% p.a. The firm has a
policy of paying all its earnings in the form of dividends. The corporate tax rate is 50%

Question 2
ABC Ltd. has the following capital structure
Amount in Rs.
4,000 Equity shares of Rs. 100 each 400,000
10% preference shares 100,000
11% Debentures 500,000

The current market price of the share is Rs. 102. The company is expected to declare a dividend of Rs.10 at the
end of the current year, with an expected growth rate of 10%. The applicable tax rate is 50%.

i) Find out the cost of equity capital and the WACC

ii)Assuming that the company can raise Rs. 300,000 12% Debentures, find out the new WACC if (a) dividend
rate is increased from 10 to 12%, (b) growth rate is reduced from 10to 8% and (c) market price is reduced to Rs.
98

Hammad J. Vohra Page 1 SZABIST

Question 3
Cyclone Software Co. is trying to establish its optimal capital structure. Its current capital structure consists of
25% debt and 75% equity, however, the CEO believes that the firm should use more debt eminent from the fact
that it is considered to be the cheapest source of finance. According to him the only factor which will increase
WACC as a result of higher debt is if the company raises debt at a cost higher than cost of equity, which can
never be the case in his opinion. He was having a discussion with some of his counterparts, where he argued that
the reason cost of equity changes is changes in dividend policy or price changes and is not affected by changes
in capital structure.

Currently, Cyclone's cost of equity is 14%. The company issued Rs. 100, 6-year 8% long-term debt instruments
a year back, which are currently trading at Rs. 92.42

The risk-free rate, rRF, is 5%; the market risk premium, RPM, is 6%; and the firm’s tax rate is 40%. Currently,
Cyclone’s cost of equity is 14%, which is determined by the CAPM.

a) Determine existing WACC of the company.

b) What would be Cyclone’s estimated cost of equity if it changed its capital structure to 50% debt and 50%
equity?

c) Based upon the Cost of Equity calculated in b) determine the revised WACC for the company and comment
as to how it affected the WACC.

e) Being a financial management expert, draft a report to the CEO elaborating as to why changes in capital
structure resulted in different cost of equity? In your write highlight areas to give an understanding about debt's
proportion in capital mix.

Question 4
Currently, Bloom Flowers Inc. has a capital structure consisting of 20% debt and 80% equity. Bloom’s debt
currently has an 8% yield to maturity. The risk-free rate (rRF) is 5%, and the market risk premium (rM – rRF) is
6%. Using the CAPM, Bloom estimates that its cost of equity is currently 12.5%. The company has a 40% tax
rate.

a. What is Bloom’s current WACC?

b. What is the current beta on Bloom’s common stock?
c. What would Bloom’s beta be if the company had no debt in its capital structure? (That
is, what is Bloom’s unlevered beta, bU?)

Bloom’s financial staff is considering changing its capital structure to 40% debt and 60% equity. If the company
went ahead with the proposed change, the yield to maturity on the company’s bonds would rise to 9.5%. The
proposed change will have no effect on the company’s tax rate.

d. What would be the company’s new cost of equity if it adopted the proposed change in capital structure?
e. What would be the company’s new WACC if it adopted the proposed change in capital structure?
f. Based on your answer to Part e, would you advise Bloom to adopt the proposed change in capital structure?
Explain.

Hammad J. Vohra Page 2 SZABIST

Question 5
XYZ Inc, is currently 100% equity financed. The company's CEO learned that debt is considered to be cheap
source of financing and hence is considering raising funds through debt issue to expand its operations in other
areas. Presently, company's required rate of return is 8%.

The yield on Government Treasury is 4%, whilst the expected market return is 9%. If the company goes ahead
with bond issue, it will raise some Rs. 4 million at interest of 7%, however this will affect its existing risk
profile and hence there might be changes in its beta coefficient. The corporate tax rate applicable on the
company is around 30%.

The current share price of company's stock is Rs. 30 per share and a total of 200,000 number of shares are
outstanding.

Required:
a) Explain why debt is considered to be a cheap financing source.
b) Calculate company's existing Beta coefficient.
c) Calculate the revised capital structure of the company (both in Rs and %)
d) Calculate the new WACC of the company and comment whether using debt really resulted in lower cost
(Yes/No, justify) HINT: Due to debt risk profile will change
e) The CEO is confused. He said that if debt is really a cheap financing sources, why not use 100% debt to run
the company? He is defending his comments based on the theory presented by Modgilani & Miller that optimal
capital structure is 100% debt. Clarify to the CEO regarding MM's theory and explain Optimal Capital Structure
with the help of Traditional View to Capital Structure.

Hammad J. Vohra Page 3 SZABIST