Question

• No maximum/minimum word count. But the calculations should be shortly explained.
• Font: Arial 12,5 pts.
• Text alignment: Justified.
• The in-text References and the Bibliography have to be in Harvard’s citation style

It assesses the following learning outcomes:

• Demonstrate a deep understanding of the theory and practices of financing a firm and its capital structure.
• Discuss and analyze the benefits of leasing versus the ownership of assets.
• Analyze the concepts underlying the WACC
• Critically evaluate dividend policy

Problem 4 (25 points)

EU Corp. would like to have a 10.4 percent weighted average cost of capital. The company’s cost of equity is 12 percent, and its pre-tax cost of debt is 8.8 percent. The tax rate is 20 percent.

What is the company’s target debt–equity ratio?

Answer 1

Theory and practices of financing a firm and its capital structure:-

Capital structure is the combination of capitals from different sources of finance. The capital of the company consists of equity share capital, preference share capital & long term external debts. Capital structure decision will decide weight of debt & equity and overall cost of capital as well as value of the firm. So capital structure is relevant in maximizing value of the firm & minimizing overall cost of capital.

Capital structure theories -> Capital structure relevance theory -> Net Income Approach

-> Traditional Approach

-> Capital structure irrelevance theory -> Net Operating Income Approach

-> Modigliani and Miller Approach

Net Income Approach

According to this approach, capital structure decision is relevant to the value of the firm. An increase in financial leverage will lead to decline in the weighted average cost of capital (WACC), while the value of the firm as well as market price of ordinary share will increase. Conversely, a decrease in the leverage will cause an increase in the overall cost of capital and a consequent decline in the value as well as market price of equity shares.

Overall cost of capital = EBIT/Value of the firm

Traditional Approach

This approach favours that as a result of financial leverage up to some point, cost of capital comes down and value of firm increases. However, beyond that point, reverse trends emerge. The principle implication of this approach is that the cost of capital is dependent on the capital structure and there is an optimal capital structure which minimises cost of capital. Optimum capital structure occurs at the point where value of the firm is highest and the cost of capital is the lowest.

Net Operating Income Approach (NOI)

NOI means earnings before interest and tax (EBIT). According to this approach, capital structure decisions of the firm are irrelevant.

Any change in the leverage will not lead to any change in the total value of the firm and the market price of shares, as the overall cost of capital is independent of the degree of leverage. As s result, the division between debt & equity is irrelevant.

As per this approach, an increase in the use of debt which is apparently cheaper is offset by an increase in the equity capitaisation rate. This happens because equity investors seeks higher compensation as they are opposed to greater risk due to the existence of fixed return securities in the capital structure.

Concept of WACC:-

WACC is expanded as weighted average cost of capital. It represemt the overall required rate of the firm. All forms of capital & debts are provided with weights to calculate WACC. Each and every project which gives return less than WACC should not be accepted. Since return on project is less than required rate of return.

Dividend policy;-

Modigiliani - Miller approach is in support of the irrelevance of dividends. i.e, firm's dividend policy has no effect on either the price of a firm's stock or its cost of capital.

Assumption in M.M Hypothesis: Perfect capital markets, Fixed investment policy, No floatation cost or transaction cost & Risk of uncertainty does not exist.

According to M.M Hypothesis, market value of its firm depends solely on its earning power and is not influenced by the manner in which its earnings are split between dividends and retained earnings.

Price in the beginning of the period = (Price at the end of the period + Dividend at the end of the period)/(1+cost of equity)

Dividend's Relevance Theory - Gordon's Model

Market price = Dividend/(Cost of capital-Growth rate)

According to Gordon's model, when IRR is greater than cost of capital, the price per share increases and dividend pay-out decreases. On other hand, when IRR is lower than the cost of capital, the price per share decreases and dividend pay-out increases.

Dividend's Relevance Theory - Walter's Model

Market price = [Dividend per share + IRR/cost of equity (EPS-Dividend per share)]/cost of equity

The above formula is given by Prof. James E.Walter shows how dividend can be used to maximise the wealth of equity holders. He argues that in the long run, share prices reflect only the present value of expected dividends.

If the internal return of retained earnings is higher than market capitalization rate, the value of ordinary shares would be high even if dividends are low. However if the internal return within the business is lower than what the market expects, the value of the share would be low. In such a case, shareholders would prefer a higher dividend so that they can utilise the funds so obtained elsewhere in more profitable opportunities.

Walter's model explains why the market price of shares of growing companies are high even though the dividend paid out is low. It also explains why the market price of shares of certain companies which pay higher dividends and retain very low profits is also high.

Last part;

WACC = Weight of equity * cost of equity + weight of debt * post tax cost of debt

where, WACC = 10.4%; cost of equity = 12%; post tax cost of debt = 8.8%*(1-0.2) = 8.8%*0.8 = 7.04%; weight of equity = "x" ; weight of debt = "1-x"

0.104 = x*0.12 + (1-x)*0.0704

0.104 = 0.12x + 0.0704 - 0.0704x

0.104-0.0704 = 0.0496x

0.0496x = 0.0336

x = 0.0336/0.0496

x = 67.75%

Weight of equity = 67.75% weight of debt = 100%-67.75% = 32.25%

Debt equity ratio = Debt weight/equity weight

= 32.25%/67.75

= 0.476