Question

Bansal Real Estate Company was founded 25 years ago by the current CEO, RanjitBansal.
The company purchases real estate, including land and buildings, and rents the property to
tenants. The company has shown a profit every year for the past 18 years, and the stock
holders are satisfied with the company’s management. Prior to BansalReal Estate Mr.
Bansal was CEO and founder of agro firm which was bankrupt because of debt financing.
So Mr. Bansal was against debt financing and therefore the Bansal Real Estate Company is
100% equity financed with 15 million shares outstanding and the stock currently trades at
Rs. 300 per share.
Bansal is evaluating a plan to purchase a huge tract of land near Kathmandu for Rs 900
million. The land will generate huge revenue so the pretax income will increase by Rs. 220
million in perpetuity. The new CFO Mr. Supreme has determined the current cost of capital
of the company is 12.5%. He feels that the company would be more valuable if it included
debt in its capital structure, so he is evaluating whether the company should issue debt to
entirely finance the new project. He thinks that the bond can be issued at par with coupon
rate of 8%. Based on some conversations with investment bank, he thinks that the 70%
equity and remaining debt would be optimal capital structure. He also thinks that higher
debt would be lowering the rating and cost would increase. The corporate tax rate is 40%.
a. If the Bansal wishes to maximize its total market value, would you recommend that it
issues debt or equity to finance land purchase? Explain
b. If the company issue debt then what would be the impact in price per share? If the
company issue equity rather thandebt, what would be the impact in price per share?

Answer 1

A} The first query to tackle is what is supposed with the aid of capital structure. The capital shape of an enterprise refers to the combination of fairness and debt finance used through the corporation to finance its assets. Some corporations may want to be all-equity-financed and have no debt at all, even as others ought to have low tiers of fairness and excessive degrees of debt. The selection on what combination of fairness and debt capital to have is known as the financing decision.

The financing selection has a direct impact on the weighted common value of capital (WACC). The WACC is the easy weighted common of the value of fairness and the fee of debt. The weightings are in percentage to the market values of fairness and debt; therefore, as the proportions of fairness and debt vary, so will the WACC. Therefore the first main factor to apprehend is that as a business enterprise adjustments its capital shape (ie varies the combination of fairness and debt finance), it will mechanically result in a trade-in its WACC.

The market cost of a corporation = Future money flows / WACC

It is indispensable to the word that the decrease the WACC, the greater the market fee of the enterprise – as you can see from the following easy example; when the WACC is 15%, the market fee of the employer is 667; and when the WACC falls to 10%, the market cost of the corporation will increase to 1,000.

The market price of a corporation

100/ 0.15 = 667

100/0.10 = 1,000

Hence, if we can alternate the capital shape to decrease the WACC, we can then make bigger the market fee of the business enterprise and consequently extend shareholder wealth.

Therefore, the search for the ideal capital shape turns into the search for the lowest WACC, due to the fact when the WACC is minimized, the fee of the company/shareholder wealth is maximized. Therefore, it is the obligation of all finance managers to discover the most useful capital shape that will end result in the lowest WACC.

What mixture of equity and debt will end result in the lowest WACC?

As the WACC is an easy common between the value of fairness and the price of debt, one’s instinctive response is to ask which of the two elements is the cheaper, and then to have extra of the lower-priced one and much less of luxurious one, to minimize the common of the two.

Well, the reply is that fee of debt is less expensive than the price of the equity. As debt is much less unstable than equity, the required return wanted to compensate the debt buyers is much less than the required return wished to compensate the fairness investors. Debt is much less volatile than equity, as the charge of activity is frequently a constant quantity and obligatory in nature, and it is paid in precedence to the charge of dividends, which are in truth discretionary in nature. Another cause why debt is much less unstable than fairness is in the match of a liquidation, debt holders would get hold of their capital reimbursement earlier than shareholders as they are greater in the creditor hierarchy (the order in which lenders get repaid), as shareholders are paid out last.

Debt is additionally more cost-effective than fairness from a company’s standpoint is due to the fact of the specific company tax cure of hobby and dividends. In the income and loss account, hobby is subtracted earlier than the tax is calculated; thus, groups get tax remedy on interest. However, dividends are subtracted after the tax is calculated; therefore, businesses do now not get any tax comfort on dividends. Thus, if hobby repayments are $10m and the tax charge is 30%, the value to the enterprise is $7m. The truth that pastime is tax-deductible is an exceptional advantage.

Let us return to the query of what combination of fairness and debt will end result in the lowest WACC. The instinctive and apparent response is to tools up by way of changing some of the extra pricey fairness with the more cost-effective debt to minimize the average, the WACC. However, issuing greater debt (ie growing gearing), an ability that extra activity is paid out of earnings earlier than shareholders can get paid their dividends. The multiplied activity charge will increase the volatility of dividend repayments to shareholders, due to the fact if the organization has a terrible year, the improved hobby repayments ought to nevertheless be paid, which may additionally have an impact the company’s potential to pay dividends. This makes it bigger in the volatility of dividend price to shareholders is additionally known as an amplify in the economic threat to shareholders. If the economic danger to shareholders increases, they will require an increased return to compensate them for this multiplied risk, accordingly the fee of fairness will make bigger and this will lead to make bigger in the WACC.

In summary, when making an attempt to discover the lowest WACC, you:

difficulty greater debt to exchange high priced equity; this reduces the WACC, but

extra debt additionally will increase the WACC.

Hence we can conclude as whatever the capital structure the company adopts it should always try to keep the WACC at a minimum level to maximize the value of the corporation.

b}

An investor’s wish for excessive returns is tempered with the aid of the quantity of threat the investor is inclined to assume. Debt versus fairness addresses this anxiety directly. Debt can be used to lever up earnings, however when overdone can lead to bankruptcy. The trick for businesses and their buyers is to apprehend the proper combine of debt and fairness to optimize boom barring committing to immoderate stages of pastime repayments that drain away money at an unsustainable rate.

Capital Structure

The capital shape of a company consists of its long-term debt and equity. Long-term debt refers to bonds and loans that mature in over one year. Equity has two components: the inventory issued by way of the enterprise and the unspent profits, regarded as retained earnings. Capital is used by way of the organisation to finance operations, buy belongings and collect different companies. The weighted average cost of capital is an expression of how a whole lot the corporation has to pay to accumulate capital. Debt generally have special acquisition costs.

Equity

Equity is the possession stake in a company, divided up amongst its frequent and favored stockholders. The “cost” of issuing inventory is the return on funding required by means of inventory investors. Return on frequent inventory is the increase in inventory charge -- fueled by means of will increase in revenue per share -- plus dividend payments, whereas favored share returns are sincerely the dividends paid. Dividends, whilst an inducement to inventory purchasers, are now not assured and may also alternate over time. Equity is “safer” than debt due to the fact failure to pay dividends will no longer end result in default. When new frequent inventory is issued, the current shareholders ride a dilution in ownership, and the earnings-per-share will right away decrease. Dilution and/or dividend rate reductions will motive buyers to promote their shares, riding down inventory prices. Since many pinnacle executives are compensated in phase with the aid of inventory rate targets, the “cost” of fairness financing can be very personal.

Debt

Debt financing can leverage earnings-per-share, due to the fact if used wisely, debt will increase income barring diluting shares. The extra debt, the extra leverage. The value of a debt instrument is its activity rate. If an agency hundreds up on debt, it will discover an increasingly more burdensome responsibility to spend money on interest. If commercial enterprise conditions, such as a downturn in sales, end result in a money shortage, then the corporation may additionally chance defaulting on its activity payments. The company’s savings ranking will fall and buyers will shun lending cash or even shopping for shares. Over-leveraged companies can discover themselves bankrupt very shortly if they don’t have enough money reserves. One different consideration: activity is tax-deductible, dividends are not.

Weighted Average Cost of Capital

The debt versus fairness difficulty is essential due to the fact it determines the weighted average cost of capital, or WACC. As its title implies, every supply of capital in the WACC is weighted with the aid of the quantity used and its after-tax cost. An environment friendly business enterprise minimizes its WACC, because in any other case it is paying too a lot to finance itself. When taking on a new capital project, a business enterprise will discover specific financing picks to discover the mixture that raises WACC the least. If a project’s share return is decrease than the company’s WACC, management will most probably now not approve it due to the fact it’s a money-loser. The debt-to-equity ratio of a agency is a image of its capital shape and a way to immediately examine the possibilities and dangers of comparable businesses inside the identical industry.

Ultimately the weighted average cost of capital plays an important role in the price per share of a corporation. Whatever means it use to finance the activity cost of the same need to be low so that the returns of the investors can be maximized. Motivated investors will give boost to the per share market price of the company.