Question

Capital Structure

The finance director of Netra plc, a company listed on the AIM (Alternative Investment Market), wishes to estimate what impact the introduction of debt
finance is likely to have on the company's overall cost of capital. The
company is currently financed only by equity.
Netra plc Summarised capital structure
	£000
Ordinary shares (25 pence par value)	500
Reserves	1,100
	1,600
The company's current share price is 420 pence, and up to £4 million of fixed
rate irredeemable debt could be raised at an interest rate of 10% per annum. The corporate tax rate is 33%.
Netra's current earnings before interest and tax are £2.5 million. These
earnings are not expected to change significantly for the foreseeable future
The company is considering raising either:

1. £2 million in debt finance;
2. £4 million in debt finance

In either case,      the debt finance will be used to repurchase ordinary shares

Required:

1. Using M&M's model in a world with corporate tax, estimate the impact on Netra's cost of capital raising:

1. £2 million: and
2. £4 million in debt finance

State clearly any assumptions that you make.

2. Briefly discuss whether or not the estimates produced in part (a) are likely to be accurate.

Answer 1

Number of Shares = Total Share value / per share value = 500,000 / 0.25 = 2,000,000

EBIT	£ 2,500,000.00
Taxes (@33%)	£    825,000.00
Net Income	£ 1,675,000.00

Current Value of Shares = Number of shares * current value = 2,000,000 * 4.2 = 8,400,000

Value of unlevered firm Vu = 8,400,000

Cost of Equity Ke = Net Income / Value of unlevered firm = 1,675,000 / 8,400,000 = 19.94%

i) Debt = 2 million

After Debt ,

Value of levered firm VL = Vu + D*t = 8,400,000+2,000,000*0.33 = 9,060,000

Market value of Debt = 2,000,000

Market value of equity = Value of levered firm VL - Market value of Debt = 9,060,000 - 2,000,000 = 7,060,000

EBIT	£ 2,500,000.00	A
Interest	£    200,000.00	B=10%*A
EBT	£ 2,300,000.00	C=A-B
Taxes	£    759,000.00	D=C*33%
Net Income	£ 1,541,000.00	E=C-D

Cost of Equity Ke = Net Income / Value of Equity = 1,541,000 / 7,060,000 = 21.83%

WACC = We*Ke + Wd*Kd*(1-t) = (7,060,000 / 9,060,000)*21.83% + (2,000,000 / 9,060,000)*(1-0.33)*10% = 18.48%

(ii)  Debt = 4 million

After Debt ,

Value of levered firm VL = Vu + D*t = 8,400,000+4,000,000*0.33 = 9,720,000

Market value of Debt = 4,000,000

Market value of equity = Value of levered firm VL - Market value of Debt = 9,720,000 - 4,000,000 = 5,720,000

EBIT	£ 2,500,000.00	A
Interest	£ 400,000.00	B=10%*A
EBT	£ 2,100,000.00	C=A-B
Taxes	£ 693,000.00	D=C*33%
Net Income	£ 1,407,000.00	E=C-D

Cost of Equity Ke = Net Income / Value of Equity = 1,407,000 / 5,720,000 = 24.60%

WACC = We*Ke + Wd*Kd*(1-t) = (5,720,000 / 9,720,000)*24.6% + (4,000,000 / 9,720,000)*(1-0.33)*10% = 17.23%

a) Assumptions made my M&M model are i) Capital market is efficient ii) Debt is risk free iii) Investors are rational iv) there is no infromation assymetery

However results obtained may not be accurate due to idealistic assumptions made in M&M .

Only corporate tax is considered .