PART-A

(a)  Brown's debt ratio before after the capital restructuring            

* 100

= 39.93%

 Brown's debt ratio before after the capital restructuring

 

 

 

 

 

 

= = 42.35%

*100

(b)  Brown's WACC before capital structure

Cost of debt = (1-T) R * 100 =(1-.4) * .06 * 100 = 3.6%

Cost of ordinary share = 11%

Cost of retained earning = (

.11 *

= 7.10%

Source of fund 6% Debt Ordinary share Retained earning

Book value 600000 500000 75000

Market value 600000 850000 75000 1525000

Proportion of each element .39 .56 .05 1.00

Cost of each element .036 .11 .071

WACC 0.01404 .0616 .00355 .07919

WACC before re-structure

7.9%

 Brown's WACC before capital structure

Source of fund 6% Debt Ordinary share Retained earning

Book value 600000 500000 75000

Market value 600000 1450000 75000 2125000

Proportion of each element .28 .68 .04 1.00

Cost of each element .036 .11 .071

WACC 0.01008 .0748 .00284 .08772

WACC after re-structure

8.78 %

(c) I will use the cost of debt 3.6% as a discount rate because it is the lowest among all other discount rate including cost of equity, retained earning and WACC. If we invest 700000 and re-structure our capital, we can invest it by selling debenture as a rate of 6 %.

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

Re- investment of 700000

PART-B
Calculation of Net present value & Internal rate of return

Step-1 : Calculation of net cash outlay

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

= =

3905000 + 60000 6000 3959000

Total cost of the equipment :

Equipment cost Software development ( 75000 * 3)

3500000 225000

Alteration of manufacturing line

180000

3905000

Cash inflow from old machine Particulars Acquition cost Accumulated dep. Book salvage value 1st year 170000 100000 70000 2nd year 305000 215000 90000

Cash salvage value result Difference

30000 Loss ( 40000) 10000 ( profit)

140000 Profit ( 50000)

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 Revenue

(-) operating income

1st year 0

2nd year 1200000

3rd year 1200000

4th year 1200000

5th year 1200000

6th year 1200000

7th year 1200000

Computer operator salary Maintenance technical Gross Margin (-) administrative expenses Training Depreciation EBIT (-)interest

120400 125000 (245400)

120400 125000 954600

120400 125000 954600

120400 125000 954600

120400 125000 954600

120400 125000 954600

120400 125000 954600

35000 547143 (827543) 0

25000 547143 382457 0

10000 547143 954600 0

547143 954600 0

547143 954600 0

547143 954600 0

547143 954600 0

EBT (-) tax 40 % NIAT (+) non cash charges NCB

(827543) (827543) 547143 (280400)

382457 152983 229474 547143 776617

954600 158943 238474 547143 785617

954600 162983 244474 547143 791617

954600 162983 244474 547143 791617

954600 162983 244474 547143 791617

954600 162983 244474 547143 791617

Step-4: calculation of Excess cash flow from equipment & spare parts (7th year)  Excess cash flow from equipment Book salvage value Cash salvage value 75000 0 (75000)

Tax savings = 75000 * .30 = 22500  Excess cash flow from equipment

Book salvage value Cash salvage value

60000 60000 Nil

Total = 60000 + 22500 = 82500

Net cash inflow for 7 years

Period 0 1 2 3 4 5 6 7 7

NCO (3959000) (280400) 776617 785617 791617 791617 791617 791617 82500

Calculation of net present value

Period 0 1 2 3 4-7 7

NCB (3959000) (280400) 776617 785617 791617 82500

Present value factor 6% 1.00 .943 .890 .840 5.582 .665

Present value amount (3959000) (264417) 691189 659918 4335076 54863 1517629

 NPV is positive thats why the equipment can be bought

Calculation of IRR

Period 0 1 2 3 4-7 7

NCB (3959000) (280400) 776617 785617 791617 82500

Present value factor 17% 1.00 .855 .731 .624 3.922 .333

Present value amount (3959000) (239742) 567707 490225 3104722 27473 (8615)

IRR = UL = 17 % -

 

= 17% - 0.034% = 16. 97 %

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

PART-C

Modigliani- Miller theorem Definition :

A financial theory stating that the market value of a firm is determined by its earning power and the risk of its underlying assets, and is independent of the way it chooses to finance its investments or distribute dividends. Remember, a firm can choose between three methods of financing: issuing shares, 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 makes no difference whether a firm finances itself with debt or equity.

Theory, a form of modern thinking to capital structure :

y Traditional theory: if a firm substitutes debt for equity, it will reduce its cost of capital so increasing the firms value:

D E D ra ! rd  re ! re  re  rd . DE DE DE

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

average cost of capital

M-M

M-M

debt/equity ratio

y Modigliani- Miller (M-M) proposition 1: The value of a firm is the same regardless of whether it finances itself with debt or equity. The weighted average cost of 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 are identical in every other respect. In particular they have the same level of operating profits: X. Let A have 1000 shares issued at 1 euro and B have issued 500 (1 euro) shares and 500 euro of debt.

Firm A Equity Debt E D 1000 0

Firm B 500 500

y 100 shares of B (1/5EB) give right to receive a return:

R!

1 1 X  rd D 5 5

y 200 shares of A (1/5EA) bought using 100 euro of borrowed money (100=1/5DB) give the same return:

1 1 R ! X  rd D . 5 5
y The two investments yield the same return (and have the same financial risk) Hence 1/5 of A must have the same value of 1/5 of B: both shares should be equally priced. If not, arbitrageurs will have profitable operations at their disposal.

Possible Firm A Firm B equilibrium Firm A Operating profits Interests X rdD 10.000 10.000 66.667 15% 66.667 15% 0% 10.000 3.600 6.400 40.000 16% 30.000 70.000 14,3% 75% 10.000 10.000 68.000 14,7% 68.000 14,7% 0%

Possible equilibrium Firm B

10.000 3.600 6400 38.000 16,8% 30.000 68.000 14,7% 78,9%

Profits of shares X-rdD Shares market value Return on equity E re

Market value of debt D Market value of firm V Av. cost of capital Debt ratio ra D/E

y 1. 2. 3.

Firm B is overvalued with respect to A. An operator owning 1% of B can: sell his shares of B for a market value of 400; borrow 300 (i.e. 1% of the debt of B) at rd = 12% buy 1% of A for a value of 667.

y He then owns 1% of the unleveraged firm but has a debt equal to 1% of that of B. His risk is unchanged. Before he had an expected return of 64 (=0.16400). Now he still have a return of 64 (he expects to receive 100 = 0.15667 but he has to pay 36 as interests). But: before he had invested 400 of his money, now only 367=667300 y Hence it is profitable to sell B (the overvalued shares) and buy A (the undervalued ones). The price of A rises and that of B falls. The table shows a possible position of equilibrium: ra is the same as it should be since, by hypothesis, A and B have the same degree of risk. By contrast, re is higher for B because its global risk, which is equal to that of A, has to be shared by a lower value of equity.

y M-M proposition 2:the rate of return on equity grows linearly with the debt ratio.

X  rd D X From: r ! and re ! a E ED re E ! ra E  D  rd D it follows that: D re ! ra  ra  rd E

and hence that:

y M-M proposition 3:the distribution of dividends does not change the firms market value: it only changes the mix of E and D in the financing of the firm.

y M-M proposition 4: in order to decide an investment, a firm should expect a rate of return at least equal to ra, no matter where the finance would come from. This means that the marginal cost of capital should be equal to the average one. The constant ra is sometimes called the hurdle rate (the rate required for capital 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 1,000 so that its market value is 10,000 = 1,000/0.1. The investment project is for 100. If it is actuated, the firms operating profits would be 1,008 and its market value 10,080. But the firms equity would be worth only 9,980 because the value of the debt has to be subtracted.

Critique of the M-M theory by showing advantages & disadvantages

y The M-M propositions are benchmarks, not end results: financing does not matter except for market imperfections or for costs (f.e. taxes) not explicitly considered. A hint that financing can matter comes from the continuous introduction of financial innovations. If the new financial products never increased the firms value, then there would be no incentive to innovate. y Non-uniqueness of ra: perhaps it is not very important. y Taxation: since interests are considered as costs, a leveraged firm has a fiscal benefit. Its operating earnings net of taxes are:

X n ! 1  t c  X  rd D  rd D ! 1  t c X  t c rd D
while for an unleveraged firm they are:
a

X n ! 1  t c X ! net profits. The difference:

t c rd D , once capitalized at r , makes the value of the leveraged firm greater than that of the t c rd D unleveraged by the amount: . At the limit: the optimal capital structure might be all debt ra
(Miller). But it is necessary to consider the personal taxation of capital gains, dividends and interests that can (partially) offset the firms tax advantages. In the absence of offsetting, nothing would stop firms from increasing debt in order to decrease taxation. There must be some costs to prevent aggressive borrowing.

Footnote:

Fiscal shield:

tc rd D ra

I have capitalized it at

According to other scholars, if you assume that: 1. the firm expects to generate profits 2. the cash flows are considered to be perpetual

>> the difference between the cash flows of the leveraged firm and that of the unleveraged firm has the same risk of the interest on debt.

>>hence you can capitalize the fiscal shield at

rd

so that:

Instead of:

VL ! Vu  tc D tc rd VL ! Vu  D ra
Fiscal shield

In any case:

VL

VU

D
But, is it correct to have an unlimited increase in

VL

? It does not seem so.

VL

Present value of distress costs Fiscal shield VU

D
The present value of the distress costs reduce the present value of the fiscal shield.

y Risk of default or of financial distress: both the firm and the lenders may consider new debt too risky. According to the trade-off theory, firms seek debt levels that balance the tax advantage of an increase of debt with the prospective costs of possible financial distress. It so predicts moderate amount of debt as optimal. But there is evidence that the most profitable firms in an industry tend to borrow the least, while their probability of entering in financial distress seems to be very low. This fact contradicts the theory because, if the distress risk is low, an increase of debt has a favourable (and almost riskless) tax effect. y Asymmetric information and agency problems. Financial policy acts as a signal for the markets: 1. A high leverage tends to improve the efficiency of the managers. So investors tend to consider the issue of new debt in a favourable way (up to a limit, of course). 2. But, as we shall see later on, the managers may decide to actuate riskier projects. To try to avoid this outcome, the equity holders favours bank indebtment because they think that the banks have powerful means 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, the would-be stock investors tend to think that the managers, acting in the interest of existing stockholders, would never issue new shares at an undervalued price. They would instead try to sell the stock at an overvalued price. Hence the market would react in an unfavourable way, i.e. by markingdown the stock price. The managers then prefer not to issue new shares even if this decisions has the effect of rejecting some profitable investment programs. 4. Hence the form of finance the managers mostly prefer is undistributed profits. But they have to consider that it is difficult to cut dividends in order to have more internal finance. In all likelihood, the market would react badly. In fact, an announcement of lower dividends is considered by investors as

an information that the firm is not in good health: the market value of the firm declines (the converse happens when there is an announcement of greater dividends). 5. The pecking order theory recognize that the internal resources and the external ones are not perfect substitutes in a world of asymmetric information between investors and managers. The formers ask for a premium in order to be compensated for the risk that the information given them by managers is not quite candid. The required premium is higher for the equity investors and lower for the debt investors. The theory then maintains that the forms of finance preferred by managers have a definite order: 1. Undistributed profits; 2. Debt; 3. Equity. This fact has a relevant impact on the firms investment decisions: insufficient internal resources and difficulties in obtaining bank loans may result in the curtailment of investments, in particular those of the small and medium size firms. 6. Conflicts between debtholders and stockholders: only arise when there is a risk of default or of financial distress. In the absence of this risk, debtholders have no interest in the firms value. But, when the risk is significant, they have to consider all the costs that would reduce the value of the debt: costs of lawyers and accountants, judiciary expenses, costs of the financial experts of the court, and so on; loss of reputation and customers. There are also Agency costs: when a firm has high debts, the shareholders have: 1. incentives to undertake riskier projects, even with the consequence of reducing the expected value of the firm. Example: Assume that the probability of both boom and depression is and

low risk Firms value Depress. Boom Exp. Val 400 800 600 Stock 0 400 200 Debt 400 400 400 Firms value 200 960 580

high risk Stock 0 560 280 Debt 200 400 300

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

Ex.: Consider a 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 for sure increase its operating 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

Boom Depression Expected value

2500 1200 1850

3400 2100 2750

Note that:

(E  X  I ! 900  600 ! 300 .

without I D 2000 1200 1600 without I E 500 0 250

The value of the firm

would be increased by the investment. But:

State of the world Boom Depression Exp. value

with I D 2000 2000 2000

with I E 1400 100 750

Note that:

E (E  I ! 500  600 so that the expected value of the equity

would be decreased by the considered investment.

y Hence, the existence of the conflict of interests means that the mere threat of default can influence a firms investment decisions in an unfavourable way. Since investors understand this risk, the market price of both the debt and the stock decline. This is another good reason for managers to operate at relatively low debt ratios. y Conflicts between managers and stockholders. The latter favour debt because, by forcing the managers to pay interest, force them to avoid inefficiencies, overinvestment and excessive utilization of the firms resources to the managers benefit. The free cash flow theory that maintains that high debt ratios increase firms value, notwithstanding the threat of financial distress, is useful to explain the behaviour of mature (cash-cow) firms that are prone to overinvest.

PART-D

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

  

= = 5.6 %

* 100 * (1-.40)

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

  

* (1-t) * 100

= = 8.13 %

*(1-.40) * 100

(c) Cost of preference share =

* 100

= 19 %

(d) Cost of ordinary share first 1.75 million =(

+ growth rate ) * 100 + G) + .115)

=( =( = 19 %

(e) Cost of ordinary share greater than 1.75 million =(

* 100 + .115) * 100

=( = 22 %

(f) Ranges of total new financing over which the firm's WACC remains constant

break 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 <= 550000, then X = $1571429. If the firm ties to raise $1600000, they will need .35 x 1600000 = $560000 from debt. Well, that means the first pot of debt is used up and 10000 has to come from the more expensive, 8.13% pot. So, $1600000 million is too much. The break is at $1571429

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

Name of sources Long term debt Preference share Ordinary share

Amount 280000 120000 400000

weights .35 .15 .50

Cost of capital 0.056 .19 .22

WACC 0.0196 0.0285 0.11 0.1581

WACC = 16 %

(h) Graphical idea of the G firm's weighted marginal cost of capital (WMCC) and IOS

WACC(B, C , D , F , G)
Name of sources Long term debt Preference share Ordinary share Amount 280000 120000 400000 weights .35 .15 .50 Cost of capital 0.056 .19 .22 WACC 0.0196 0.0285 0.11 0.1581

WACC = 16 %

WACC(A, E )

Name of sources Long term debt Preference share Ordinary share

Amount 280000 120000 400000

weights .35 .15 .50

Cost of capital 0.056 .19 .19

WACC 0.0196 0.0285 0.095 0.1431

WACC = 14 %

X axis = Investment schedule opportunity Y axis = IRR & WACC

30%

25%

20%

15%

IRR WACC

10%

5%

0% A B C D E F G

(i) Recommended investment :

Project A B C D E F G

IRR 14% 25% 17% 14% 19% 16% 15%

Initial Investment $300,000 $400,000 $600,000 $500,000 $300,000 $800,000 $400,000

WACC 14 % 16 % 16 % 16 % 14 % 16 % 16 %

Explanation : Here, we should choose B. Because in proposal of B IRR is highest than A,C, D, E, F, G. Also, the WACC is only 16 % which is also the minimum cost of capital. So, if we go for the proposal B , we will be benefited by our highest IRR 25 % & the cost of capital 16 %

Bibliography
1. Advanced Corporate Finance y Krishnamurti & Viswanath

2. Advanced Management Accounting y Kaplan & Atkinson

3. Budgeting: Profit Planning and Control y 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