Question

FLG is a large listed food processing company. The board of directors of FLG are exploring various means to lower the overall cost of funding. One of the options discussed is to issue more bonds and use the proceeds to repurchase shares. One director commented, “Since debt is always cheaper than equity, we should increase leverage to reduce our cost of funding.” There is intense debate in the boardroom as some directors are believe that changing FLG’s capital structure will increase FLG’s value while the rest are still not convinced.

FLG’s financial data:
No. of shares issued: 80 million
Current price per share: $1.20
Dividend just paid: $0.06
Dividend growth rate: 5% per annum
No. of bonds issued: 50,000
Par value of each bond: $1,000
Coupon rate: 5%
Current yield to maturity: 4.5%
Time to maturity: 3 years
Market data:
10-year government bond yield: 2%
Equity risk premium: 5%
Corporate tax rate: 20%
(a) Employ the dividend growth model to determine FLG’s cost of equity.

(b) Use the capital asset pricing model (CAPM) to determine FLG’s cost of equity.

(c) Discuss the suitability of the dividend growth model and the capital asset pricing model (CAPM) based on the assumptions used to compute the cost of equity.

(d) Compute FLG’s weighted average cost of capital.

(e) Explain why the cost of equity is greater than the cost of debt.

(f) Discuss whether changing the capital structure can lead to reduction in FLG’s cost of capital and increase the value of the company.

Answer 1

No. of shares issued	80 million
Current price per share	$1.20
Total Market value	96,000,000
Dividend just paid	$0.06	<--D0
Dividend growth rate	5%	<--g
No. of bonds issued	50,000
Par value of each bond	$1,000
Market value of debt	$50,000,000
Total debt + Equity	146,000,000
Debt/Total Assets	34%	<--Wd
Debt/Total Assets	66%	<--We
Coupon rate	5%
Current yield to maturity	4.50%	<--Kd
Time to maturity	3
Market data
10-year government bond yield	2%	<--Rf
Equity risk premium	5%	<--Rm
Corporate tax rate	20%
	a)	Dividend Growth Model
		Price=	Do*(1+g)/(Cost of equity-g)
		Where,
		D0=Dividend just paid
		g=Dividnd growth rate
		Cost of equity=	10.25%	<--Ke
	b)	CAPM	Rf+Beta*(Rm-Rf)
		We don’t have beta to calculate the CAPM cost of equity
	c)	It is better to use DDM in this case as for CAPM we need beta of the companys stock
	d)	WACC	Ke*We+Kd*Wd*(1-T)
			7.97%
	e)	Equity holders have the last claim on the assets of the company in case of liquidation. Thus the return required by investors for investing in them will be highest
	f)	As per MM proposition in case of taxes the value of increases if we increase debt in the capital structure equivalent to intrest tax sheild

The above table gives the case facts along with all the answers.

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