Unformatted text preview: FINS1613 BUSINESS FINANCE TUTORIAL WEEK 10 (Based on Lecture 9, RTBWJ Chapters 12 & 15) [1] Read and ponder on possible solutions to questions under CRITICAL THINKING AND CONCEPTS REVIEW 12.5‐12.9 5. The primary advantage of the DCF model is its simplicity. The method is disadvantaged in that (1) the model is applicable only to firms that actually pay dividends; many do not; (2) even if a firm does pay dividends, the DCF model requires a constant dividend growth rate forever; (3) the estimated cost of equity from this method is very sensitive to changes in growth‐g, which is a very uncertain parameter; and (4) the model does not explicitly consider risk, although risk is implicitly considered to the extent that the market has impounded the relevant risk of the share into its market price. While the share price and most recent dividend can be observed in the market, the dividend growth rate must be estimated. Two common methods of estimating g are to use analysts’ earnings and payout forecasts, or determine some appropriate average historical g from the firm’s available data. 6. Two primary advantages of the SML approach are that the model explicitly incorporates the relevant risk of the share, and the method is more widely applicable than is the DCF model, since the SML doesn’t make any assumptions about the firm’s dividends. The primary disadvantages of the SML method are (1) estimating three parameters: the risk‐free rate, the expected return on the market, and beta, and (2) the method essentially uses historical information to estimate these parameters. The risk‐free rate is usually estimated to be the yield on very short maturity risk free debt and is hence observable; the market risk premium is usually estimated from historical risk premiums and hence is not observable. The share beta, which is unobservable, is usually estimated either by determining some average historical beta from the firm and the market’s return data, or using beta estimates provided by analysts and investment firms. In a dividend imputation system the additional value of the tax credits on dividends needs be accounted for and this will depend on the level of franking credits generated and the ability of the shareholders to use them. 7. The appropriate aftertax cost of debt to the company is the interest rate it would have to pay if it were to issue new debt today. Hence, if the YTM on outstanding bonds of the company is observed, the company has an accurate estimate of its cost of debt. If the debt is privately placed, the firm could still estimate its cost of debt by (1) looking at the cost of debt for similar firms in similar risk classes, (2) looking at the average debt cost for firms with the same credit rating (assuming the firm’s private debt is rated), or (3) consulting analysts and investment bankers. Even if the debt is publicly traded, an additional complication is when the firm has more than one issue outstanding; these issues rarely have the same yield because no two issues are ever completely homogeneous. 8. a. b. c. This only considers the dividend yield component of the required return on equity. This is the current yield only, not the promised yield to maturity. In addition, it is based on the book value of the liability, and it ignores taxes. Equity is inherently riskier than debt (except, perhaps, in the unusual case where a firm’s assets have a negative beta). For this reason, the cost of equity exceeds the cost of debt. If taxes are considered in this case, it can be seen that at reasonable tax rates, the cost of equity does exceed the cost of debt. 9. ROutback = .12 + .75(.08) = .18 or 18% Both should proceed. The appropriate discount rate does not depend on which company is investing; it depends on the risk of the project. Since Outback is in the business, it is closer to a pure play. Therefore, its cost of capital should be used. With an 18% cost of capital, the project has an NPV of $1 million regardless of who takes it. 15.2, 15.8 2. From the previous question, economies of scale are part of the answer. Beyond this, debt issues are simply easier and less risky to sell from an investment bank’s perspective. The two main reasons are that very large amounts of debt securities can be sold to a relatively small number of buyers, particularly large institutional buyers, such as superannuation funds and insurance companies, and debt securities are much easier to price. 8. He could have done worse since his access to the oversubscribed and, presumably, underpriced issues was restricted, while the bulk of his funds were allocated in shares from the undersubscribed and, quite possibly, overpriced issues. [2] Solve these problems from Chapters 12 & 15 under QUESTIONS AND PROBLEM Q12.3, Q12.4, Q12.7, Q12.9, Q12.26, Q12.30 3. We have the information available to calculate the cost of equity, using the CAPM and the dividend growth model. Using the CAPM, we find: RE = .045+ 0.90(.08) = .1170 or 11.70% And using the dividend growth model, the cost of equity is RE = [$2.60(1.05)/$48] + .05 = .1069 or 10.69% Both estimates of the cost of equity seem reasonable. If we remember the historical return on the all ordinaries index, the estimate from the CAPM model is about average, and the estimate from the dividend growth model is about two percent lower than the historical average, so we cannot definitively say one of the estimates is incorrect. Given this, we will use the average of the two, so: RE = (.1170 + .1069)/2 = .1119 or 11.19% 4. To use the dividend growth model, we first need to find the growth rate in dividends. So, the increase in dividends each year was: g1 = ($1.62 – 1.47)/$1.47 g1 = .1020 or 10.20% g2 = ($1.67 – 1.62)/$1.62 g2 = .0309 or 3.09% g3 = ($1.78 – 1.67)/$1.67 g3 = .0659 or 6.59% g4 = ($1.89 – 1.78)/$1.78 g4 = .0618 or 6.18% So, the average arithmetic growth rate in dividends was: g = (.1020 + .0309 + .0659 + .0618)/4 g = .0651 or 6.51% Using this growth rate in the dividend growth model, we find the cost of equity is: RE = [$1.89(1.0651)/$65.00] + .0651 RE = .0961 or 9.61% Calculating the geometric growth rate in dividends, we find: $1.89 = $1.47(1 + g)4 g = .0648 or 6.48% The cost of equity using the geometric dividend growth rate is: RE = [$1.89(1.0648)/$65.00] + .0648 RE = .0958 or 9.58% 7. a. The pretax cost of debt is the YTM of the company’s bonds, so: 9. P0 = $1,080 = $40(PVIFAR%,46) + $1,000(PVIFR%,46) R = 3.639% YTM = 2 × 3.639% YTM = 7.28% b. The aftertax cost of debt is: RD = .0728(1 – .30) RD = .05095 or 5.095% c. The after‐tax rate is more relevant because that is the actual cost to the company. a. Using the equation to calculate the WACC, we find: WACCclassical tax = .70(.14) + .05(.06) + .25(.075)(1 – .30) WACCclassical tax = .1141 or 11.41% Assuming that the preference and ordinary shares carry 100% franking credits at the 30% tax rate WACCimputation tax = .70(.14)(1 – 0.30) + .05(.06)(1 – 0.30) + .25(.075)(1 – 0.30) WACCimputation tax = 0.0838 or 8.38% b. Since interest is tax deductible and dividends are not in a classical tax system, we must look at the after‐tax cost of debt, which is: RD = .075(1 – .30) RD = .0525 or 5.25% Hence, on an after‐tax basis, debt is cheaper than the preference shares in a classical tax system. However in an imputation system if the preference shares have a lower return and are fully franked dividends paid then they would be a cheaper form of financing. 26. First, we need to find the project discount rate. The project discount rate is the company’s cost of capital plus a risk adjustment factor. A debt‐equity ratio of .50 implies a weight of debt of .50/1.50 and a weight of equity of 1/1.50, so the company’s WACC is: WACC = (.50/1.50)(.07) + (1/1.50)(.14) WACC = .1167 or 11.67% Adjusting for risk, the project discount rate is: Project discount rate = .1167 + .02 Project discount rate = .1367 or 13.67% The company should only accept the project if the NPV is zero (hopefully greater than zero.) The cash flows are a growing annuity. The present value of a growing annuity can be found with the dividend discount equation. So, the present value of the savings is: PV = [$4,500,000/(.1367 – .04)] PV = $46,551,724.14 The project should only be undertaken if its cost is less than $46,551,724.14. 30. We can use the debt‐equity ratio to calculate the weights of equity and debt. The debt of the company has a weight for long‐term debt and a weight for accounts payable. We can use the weight given for accounts payable to calculate the weight of accounts payable and the weight of long‐term debt. The weight of each will be: Accounts payable weight = .20/1.20 = .17 Long‐term debt weight = 1/1.20 = .83 Since the accounts payable has the same cost as the overall WACC, we can write the equation for the WACC as: WACC = (1/1.8)(.17) + (0.8/1.8)[(.20/1.2)WACC + (1/1.2)(.09)(1 – .30)] Solving for WACC, we find: WACC = .0944 + .4444[(.20/1.2)WACC + .0525] WACC = .0944 + (.0741) WACC + .0233 (.9259)WACC = .1177 WACC = .1271 or 12.71% Since the cash flows go to perpetuity, we can calculate the present value using the equation for the PV of a perpetuity. The NPV is: NPV = –$80,000,000 + ($10,900,000/.1271) NPV = $5,759,244.69 Q15.4, Q15.5, Q15.6 4. We need to calculate the net amount raised and the costs associated with the offer. The net amount raised is the number of shares offered times the price received by the company, minus the costs associated with the offer, so: Net amount raised = (4,100,000 shares)($22.00) – 780,000 – 250,000 Net amount raised = $89,170,000 The company received $89,170,000 from the share offering. Now, we can calculate the direct costs. Part of the direct costs are given in the problem, but the company also had to pay the underwriters. The share was offered at $23.65 per share, and the company received $22.00 per share. The difference, which is the underwriters spread, is also a direct cost. The total direct costs were: Total direct costs = $780,000 + ($23.65 – 22.00)(4,100,000 shares) Total direct costs = $7,545,000 We are given part of the indirect costs in the problem. Another indirect cost is the immediate price appreciation. The total indirect costs were: Total indirect costs = $250,000 + ($28.00 – 23.65)(4,100,000 shares) Total indirect costs = $18,085,000 This makes the total costs: Total costs = $7,545,000 + 18,085,000 Total costs = $25,630,000 The floatation costs as a percentage of the amount raised is the total cost divided by the amount raised, so: Floatation cost percentage = $25,630,000/$89,170,000 Floatation cost percentage = .2874 or 28.74% 5. Using X to stand for the required sale proceeds, the equation to calculate the total sale proceeds, including floatation costs is: X(1 – .06) = $34,000,000 X = $36,170,213 required total proceeds from sale. So the number of shares offered is the total amount raised divided by the offer price, which is: Number of shares offered = $36,170,213/$32 Number of shares offered = 1,130,319 6. This is basically the same as the previous problem, except that we need to include the $1,450,000 of expenses in the amount the company needs to raise, so: X(1 – .06) = $35,450,000 X = $37,712,766 required total proceeds from sale. Number of shares offered = $37,712,766 /$32 Number of shares offered = 1,178,524 [3] Answer the following Multiple‐choice questions 1. Which of the following is not considered a capital component for the purpose of calculating the weighted average cost of capital (WACC) as it applies to capital budgeting? a. Long‐term debt. b. Common stock. c. Accounts payable and accruals. d. Preferred stock. e. None of these answers Answer is (c) 2. Wyden Brothers has no retained earnings. The company uses the CAPM to calculate the cost of equity capital. The company's capital structure consists of common stock, preferred stock, and debt. Which of the following events will reduce the company's WACC? a. A reduction in the market risk premium. b. An increase in the flotation costs associated with issuing new common stock. c. An increase in the company's beta. d. An increase in expected inflation. e. An increase in the flotation costs associated with issuing preferred stock. Answer is (a). If RPM decreases, the cost of equity will be reduced. Answers b through e will all increase the company's WACC. 3. Conglomerate Inc. consists of 2 divisions of equal size, and Conglomerate is 100 percent equity financed. Division A's cost of equity capital is 9.8 percent, while Division B's cost of equity capital is 14 percent. Conglomerate's composite WACC is 11.9 percent. Assume that all Division A projects have the same risk and that all Division B projects have the same risk. However, the projects in Division A are not the same risk as those in Division B. Which of the following projects should Conglomerate accept? a. Division A project with an 11 percent return. b. Division B project with a 12 percent return. c. Division B projectwith a 13 percent return. d. Statements a and c are correct. e. Statements b and d are correct. Answer is (a). Division A should accept only projects with a return greater than 9.8 percent, and Division B should accept only projects with a return greater than 14 percent. Only statement (a) fits this criteria. The company's composite WACC is irrelevant in the decision. ...
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