Question

1. You are a finance manager for the company JKL Limited based in the US. Your CFO comes to you and tells you that you intend to make a debt funding for a new 5-year project in Austria. Since he is not very familiar with such a funding, he tells you that he has heard of different aspects or variables of such a funding. Please name those and explain briefly.
2. Company JKL Limited has 10 million stocks outstanding. The shares are trading at 60$ per share. It also has 400 bonds outstanding – each valued at 500.000$. The marginal tax-rate is at 30%. For the expected return of the shareholders is about 14% and the interest rate for the bonds is at 8%. What is JKL’s after-tax WACC?

3. Recently you have been invited to the Directors meeting to decide on the future capital structure for the firm. One of your colleagues came with the following argument: “As the firm borrows more and debt becomes risky, both stockholders and bondholders demand higher rates of return. Thus, by reducing the debt ratio we can reduce both the cost of debt and the cost of equity, making everybody better off.”

   Using the argument of M&M Proposition I“The market value of a company is independent of its

   capital structure”, suggest why this argument is not relevant, for simplicity ignore the tax implications.

4. An investor considers whether to invest in debt or equity of STU Corporation. Since he already has to pay a high personal tax rate, he does not want to pay more taxes than necessary. Therefore, he weighs the pros and cons of investing in bonds or equities in the local financial markets. The personal tax rate on interest income is 45%, the corporate tax rate is 27.5% and the tax rate on dividends is 20%. Which strategy do you recommend the investor?  

5. STU Corporation wants to assess the value of interest savings due to the tax deductibility of interest on debt. The corporate tax rate is given above. The total debt stands at $ 7.5mn and the return on debt is 6.5%. Assuming that the current level of debt is permanent, calculate the annual interest payment due and the present value of the perpetual tax shield. Explain in what situations a tax shield might be less relevant and/or even misleading.

6. Most financial managers measure debt ratios from their companies’ book balance sheets. Many financial economists emphasize ratios from market-value balance sheets. Which is the right measure in principle? Does the trade-off theory propose to explain book or market leverage? How about the pecking-order theory?

7. The VWX Inc. has 100,000 bonds outstanding (1000$ each) that are selling at 100%. The bonds are yielding 7.5 percent. The company also has 1 million shares of preferred stock outstanding currently yielding 18.75 percent. It has also 5 million shares of common stock outstanding. The preferred stock sells for $56 per share and the common stock sells for $38 a share. The expected return on the common stock is 13.8%. The corporate tax rate is 34 percent. What is VWX Inc.’s weighted average cost of capital

8. The WACC formula implies that debt is “cheaper” than equity, that a firm with more debt could use lower discount rate. Does this make sense?  

9. The Rockettech Corp. is currently at its target debt ratio of 40%. It is contemplating a $1 million expansion of its existing business. This expansion is expected to produce a cash inflow of $130,000 a year in perpetuity.

   The company is uncertain whether to undertake this expansion and how to finance it. The two options are a $1 million issue of common stock or a $1 million issue of 20-year debt. The flotation costs of a stock issue would be around 5% of the amount raised, and the flotation costs of a debt issue would be around 1.5%.

   Rockettech’s financial manager, estimates that the required return on the company’s equity is 14%, but argues that the flotation costs increase the cost of new equity to 19%. On this basis, the project does not appear viable. On the other hand, she points out that the company can raise new debt on a 7% yield, which would make the cost of new debt 8.5%. She therefore recommends that Rockettech should go ahead with the project and finance it with an issue of long-term debt.

   Is the financial manager right? How would you evaluate the project, considering that the project has the same business risk as the firms other assets?

Answer 1

a)

Debt funding/financing is a method to raise money for capital expenditures or working capital requirements of a company. The money is received in exchange for selling debt instruments like bonds to individuals or institutional investors. In return for lending the money, the person holding the bond becomes a creditor and will receive the principal amount at an agreed date plus an added interest. This interest the borrower has to pay annually is called the cost of debt and is also called as coupon payments.

The formula for the cost of debt financing is:

KD = cost of debt

KD = Interest Expense x (1 - Tax Rate)

As interest on debt is tax-deductible, it is calculated on an after-tax basis to make it comparable to the cost of equity as earnings on stocks are taxed.

In addition to paying interest, debt financing requires the borrower to follow certain rules regarding the financial performance of the company. These rules are called as covenants.

b)

A weighted avg cost of capital(WACC) represents a blended cost of capital across all sources from where the company gets its capital. The cost of each type of capital is weighted by its percentage of total capital and are added together.

WACC is used as a discount rate to calculate net present value(NPV) of a business.

We can calculate WACC by the following formula,

WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))

Where:

E = market value of equity (market cap)
D = market value of debt
V = total value of capital (E + D)
Re = cost of equity
Rd = cost of debt
T = tax rate

We are given,

Stocks outstanding = 10,000,000

Price per share = $60

The market value of equity = No. of stocks outstanding * price per share = 60*10,000,000 = 600,000,000

The market value of bonds = 400*500,000 = 200,000,000

Tax rate = 30%

cost of debt = 8%

cost of equity = 14%

Putting these values in the formula we get,

WACC =

WACC = (.75 * .14) + (( .25 * .08) * ( .70))

WACC = .105 + ( .02 * .70)

WACC = .105 + .014

WACC = 11.9%