Question 7
a) The two different sources of equity finance that are available with the company for raising equity finance is through private placement of stocks with the potential investors or the venture capital firms and even through the Business Angels.
Business Angels: Business Angels are wealthy high net worth individuals that invests in a high growth business in return for a share in the company. The Business Angels are often referred as experienced entrepreneurs, who not only support the operations of the company with their experience and ideas they also provide capital support required for expansion and carrying on business activities. The key risk involved in tis financing approach will be that the Owners would not be able to solely enjoy the profitability and growth aspects of the company they have to share their profit with the Business Angels.
Venture Capital: The venture capital are also known as a private equity financing that are looking or willing to invest a hefty amount of money for a higher form of return on equity desired by the venture capitalist. The key risk that the company would be running in this case would be in the form of pressure on profitability margins and better performance so that the Venture Capital get their desired amount of return.
b)
i)
| Right Share Required | |
| Finance Amount | 8,000,000 |
| Price of Rights Share | 4 |
| Total Number of Shares | 2,000,000 |
ii) Shares Required for Buying Right Share can be well derived with the help of existing shares the company is having and the new shares that will be issued. In total for every investors having 3 shares will be getting 1 right share. The ratio is 3:1
| Shares Required for Buying Right Share | |
| Existing Shares | 6,000,000 |
| New Shares Issued | 2,000,000 |
| Share Required | 3 |
iii) Theoretical Ex-Right Share Price
| Theoretical Ex-Right Share Price | |
| Current Market Cap | 30,000,000 |
| Outstanding Shares | 6,000,000 |
| Share Price | 5 |
| Additional Equity Raised | 8,000,000 |
| New Market Cap | 38,000,000 |
| Outstanding Shares | 6,000,000 |
| New Share Price | 6.33 |
iv) Value of Rights Share
| Value of Rights Share | |
| New Share Price | 6.33 |
| Existing Share Price | 5 |
| Value of Right Share | 1.33 |
v) New Value of Bright Ltd
| New Value of Bright Ltd | |
| Current Market Cap | 30,000,000 |
| Additional Equity Raised | 8,000,000 |
| Total Value of Bright Ltd | 38,000,000 |
Question 6
a) i) Convert Ltd After Tax Cash Flows
| Particulars | Amount ($) |
| EBIT | 80,000 |
| Interest | 0 |
| Tax Rate | 30% |
| Tax Amount | 24,000 |
| After Tax Cash Flow | 56,000 |
ii)
| Market Value | |
| Growth Rate | Perpetuity |
| After Tax Cash Flow | 56,000 |
| Cost of Capital | 14% |
| Value: Cash Flow/Cost of Capital | |
| Value | 400,000 |
iii)
| Particulars | Amount ($) |
| EBIT | 80,000 |
| Interest (100,000*10%) | -10,000 |
| Tax Rate | 30% |
| Tax Amount | -24,000 |
| After Tax Cash Flow | 46,000 |
| New Market Value | |
| Growth Rate | Perpetuity |
| After Tax Cash Flow | 46,000 |
| Cost of Capital | 14% |
| Value: Cash Flow/Cost of Capital | |
| Value | 328,571 |
iv)
| New Value of Equity | |
| Market Value | 328,571 |
| Less: Debt | 100,000 |
| New Value of Equity | 228,571 |
b)
i) The M&M theory approach which well says that with the assumption of no taxes well says that the capital structure does not affect or influence the valuation of the firm. In other terms it can be said that the leveraging would not help the company increasing the market value for the company. The same also suggest that debt holders that are in the company and equity shareholders both have the same priority in terms of earnings which are split equally. It also says that with the increase in the debt component in the financing part, the equity shareholders tend to face or have a higher amount of risk. Hence increase in risk leads to increase in the cost of equity for the company and the overall cost of capital for the company.
ii) The M&M Approach assumes that there are no taxes however, in the real world that is far from the truth. Companies are taxed based on the individual tax structure that is prevailing in countries. The theory well recognizes the fact that tax benefits accrued by interest payments. Tax deductible interest expenses or in the form of tax shield the company gets from interest payment lowers the cost of debt for the company. However, the same is not in the case of equity financing the same is not applicable. Thus, the company can maximize its debt borrowings so that it can well increase it in order to reduce the debt value. However, on the other hand, cost of financial distress or financial risk increases considerably as the company raises more and more amount of debt financing.
Question 5
a)
| WACC | ||
| Cost of Equity | ||
| Dividend Growth Model | ||
| Dividend (Do) | $ 0.45 | |
| Growth Rate | 4% | |
| Dividend (D1) | $ 0.47 | |
| Price (Po) | $ 3.00 | |
| Re:(D1/Po)+Growth Rate | ||
| Cost of Equity | 19.60% | |
| Cost of Debt | ||
| Nominal Int. Rate | 11% | |
| Tax Rate | 30% | |
| Effective Cost of Debt | 7.70% | |
| Cost of Preference Share | 14.00% | |
| Particulars | Amt ($) | Weight (%) |
| Market Value of Equity | 72000000 | 44.44% |
| Market Value of Debt | 36000000 | 22.22% |
| Market Value of Preference Share | 54000000 | 33.33% |
| Total Capital | 162000000 | 100.00% |
| WACC | 15.09% |
B) Base Case
| WACC | ||
| Cost of Equity | ||
| Dividend Growth Model | ||
| Risk Free Rate | 5% | |
| Market Return | 15% | |
| Beta | 1.45 | |
| Re: Rf+(Rm-Rf)*Beta | ||
| Cost of Equity | 19.50% | |
| Cost of Debt | ||
| Nominal Int. Rate | 11% | |
| Tax Rate | 30% | |
| Effective Cost of Debt | 7.70% | |
| Cost of Preference Share | 14.00% | |
| Particulars | Amt ($) | Weight (%) |
| Market Value of Equity | 72000000 | 44.44% |
| Market Value of Debt | 36000000 | 22.22% |
| Market Value of Preference Share | 54000000 | 33.33% |
| Total Capital | 162000000 | 100.00% |
| WACC | 15.04% |
Project P WACC
| WACC (Project P) | ||
| Cost of Equity | ||
| Dividend Growth Model | ||
| Risk Free Rate | 5% | |
| Market Return | 15% | |
| Beta | 1.80 | |
| Re: Rf+(Rm-Rf)*Beta | ||
| Cost of Equity | 23.00% | |
| Cost of Debt | ||
| Nominal Int. Rate | 11% | |
| Tax Rate | 30% | |
| Effective Cost of Debt | 7.70% | |
| Cost of Preference Share | 14.00% | |
| Particulars | Amt ($) | Weight (%) |
| Market Value of Equity | 72000000 | 44.44% |
| Market Value of Debt | 36000000 | 22.22% |
| Market Value of Preference Share | 54000000 | 33.33% |
| Total Capital | 1.62E+08 | 100.00% |
| WACC | 16.60% |
Project Q
| WACC (Project Q) | ||
| Cost of Equity | ||
| Dividend Growth Model | ||
| Risk Free Rate | 5% | |
| Market Return | 15% | |
| Beta | 0.90 | |
| Re: Rf+(Rm-Rf)*Beta | ||
| Cost of Equity | 14.00% | |
| Cost of Debt | ||
| Nominal Int. Rate | 11% | |
| Tax Rate | 30% | |
| Effective Cost of Debt | 7.70% | |
| Cost of Preference Share | 14.00% | |
| Particulars | Amt ($) | Weight (%) |
| Market Value of Equity | 72000000 | 44.44% |
| Market Value of Debt | 36000000 | 22.22% |
| Market Value of Preference Share | 54000000 | 33.33% |
| Total Capital | 162000000 | 100.00% |
| WACC | 12.60% |
Question 4
a) If we increase the number of stocks in the portfolio then the unsystematic risk associated with the portfolio gets reduced due to the benefit of diversification. However, systematic risk would not be reduced if we increase the number of stocks in the portfolio.
b) Security Risk Premium are calculated with the help of taking the beta of the stock into account whereby the formula in this case is Security Risk Premium: Beta*(Return on Market-Risk Free Rate). On the other hand, the market risk premium is calculated with the help of the formula: (Return on Market-Risk Free Rate). Beta is the key factor which is not incorporated in the Market Risk Premium.
c) i)
| Over Ltd | Under Ltd | |||
| Cost of Equity | Cost of Equity | |||
| Dividend Growth Model | Dividend Growth Model | |||
| Risk Free Rate | 6% | Risk Free Rate | 6% | |
| Market Return | 14% | Market Return | 14% | |
| Beta | 1.50 | Beta | 0.80 | |
| Re: Rf+(Rm-Rf)*Beta | Re: Rf+(Rm-Rf)*Beta | |||
| Cost of Equity | 18.00% | Cost of Equity | 12.40% |
ii) Over Ltd should be selected for investment
| Over Ltd | Under Ltd | |||
| Cost of Equity | Cost of Equity | |||
| Dividend Growth Model | Dividend Growth Model | |||
| Risk Free Rate | 6% | Risk Free Rate | 6% | |
| Market Return | 14% | Market Return | 14% | |
| Beta | 1.50 | Beta | 0.80 | |
| Re: Rf+(Rm-Rf)*Beta | Re: Rf+(Rm-Rf)*Beta | |||
| Cost of Equity | 18.00% | Cost of Equity | 12.40% | |
| Realised Return | 19.00% | Realised Return | 12.00% | |
| Excess Return (Alpha) | 1.00% | Excess Return (Alpha) | -0.40% |
d)
i)
| CAPMAN Ltd | |
| Cost of Equity | |
| Dividend Growth Model | |
| Risk Free Rate | 4% |
| Market Return | 12% |
| Beta | 1.50 |
| Re: Rf+(Rm-Rf)*Beta | |
| Cost of Equity | 16.00% |
| Security Risk Premium | 12.00% |
ii) MRP
| CAPMAN Ltd | |
| Cost of Equity | |
| Dividend Growth Model | |
| Risk Free Rate | 4% |
| Market Return | 12% |
| Beta | 1.50 |
| Re: Rf+(Rm-Rf)*Beta | |
| Cost of Equity | 16.00% |
| Security Risk Premium | 12.00% |
| Market Risk Premium | 8.00% |
III) Beta measures the systematic risk associated with the portfolio
iv) A beta of 1.50 says that if the market moves by 1.50 times the stock is expected to move by around 1.50 times in the same direction as the market moves.
e)
| SRP | |
| Cost of Equity | |
| CAPM | |
| Risk Free Rate | 6% |
| Market Return | 10% |
| Beta | 1.40 |
| Re: Rf+(Rm-Rf)*Beta | |
| Cost of Equity | 11.60% |
Question 3
a)
| Project | 0 | 1 | 2 | 3 | 4 | NPV | IRR |
| FAST | -24 | 6.8 | 8.4 | 11.2 | 14.8 | $4.81 | 22% |
| NORM | -24 | 13.2 | 11.6 | 7.2 | 5.2 | $4.38 | 24% |
b) Project Fast should be accepted as this is having a higher NPV
c) Cross Over Rate: 23% : (22+24)/2
