Question

FAKE PLC is a television programme broadcaster and producer. The firm is currently all equity funded. FAKE has 10 million shares outstanding, with a price of £40 per share. FAKE plans to raise £160 million to fund its programme expansion by issuing new shares.

Before the issue of new shares, FAKE's equity Beta was 0.8, the riskfree interest rate was 2% and the market's expected return on equity was 6%.

Assume there are perfect markets, with no taxes.

1. How many new shares must FAKE issue, to raise £160 million?  
2. After issue of new shares, FAKE's equity Beta rises to 1.0. The risk-free interest rate and market's expected return are the same. Use CAPM to calculate the pre- and post-expansion return on equity for FAKE PLC.
3. Suppose that FAKE raises £160m by issuing debt instead of equity, and that the cost of debt for FAKE is 3.2%. What is FAKE’s return on equity before and after the debt issue?
4. What is FAKE’s WACC before and after the debt issue? Illustrate your answer with a diagram.

Answer 1

FAKE PLC.
Details	Amt Pound
As the Market in perfect ,we can assume that
the new shares can be issued at existing price
of Pound 40/Share
Ans a.
Amount of New share capital	160,000,000
Price per new share	40
Number of shares to be issue=160M/40=	4,000,000
Ans b.
Cost of Equity =Re=Rf+beta(Rm-Rf)
Rf=Risk free rate. Rm=expected market return
	Pre -expansion cost	Post -expansion cost
Risk Free Rate =Rf=	2%	2%
Expected return from market=Rm=	6%	6%
Equity Beta	0.8	1
Cost of Equity =Re=Rf+beta(Rm-Rf)	= 2%+0.8*(6%-2%)	=2%+1*(6%-2%)
Cost of Equity =	5.200%	6.00%
Ans c
Let geraed cost of equity after debt issue=Rg
g=Ru+ D/E(Ru-Rd)
Now debt =	160,000,000.00
Equity=	400,000,000.00
D/E =	0.40
Rd= cost of debt=	3.20%
Ru= Ungeraed equity cost before debt issue=	5.20%
Rg=5.2%+0.4*(5.2%-3.2%)= 6%
So Cost of Equity after debt issue =6%
Ans d.
Before debt issue , Equity was 100%
So WACC before debt issue =5.2%
After Debt issue , WACC= Rg*E/(D+E) +Rd*D/(D+E)
Rg=6%
Rd=3.2%
E/D+E= 400M/560M=	0.714
D/D+E=160M/560M=	0.286
So WACC =6%*0.714+3.2%*0.286 =5.2%
So WACC afte debt issue is also 5.2%