Question

Assume you have just been hired as a Finance Manager of Anjung Puteri. The company’s earnings before interest and taxes (EBIT) was RM500,000 last year and is expected to remain constant over time. Since no expansion capital will be required, Anjung Puteri plans to pay out all earnings as dividends. The management group owns fifty percent (50%) of the stock and the rest is traded in the over-the-counter market.

In your finance course, you learned that most firm owners would be financially better off if the firm used some debt. When you suggested this to your new boss, she encouraged you to pursue the idea. Anjung Puteri is currently financed with all equity, it has 100,000 shares outstanding and the current market price is RM15 per share. If Anjung Puteri were to recapitalize, debt would be used, and the funds received would be used to repurchase stock at the RM15 per share market price. Anjung Puteri is in a 24% tax bracket. The company leases all its equipment and its building. Therefore, Anjung Puteri has no depreciation expense.

From your finance training, you know that there is an optimum relationship between debt and equity at which the market value per share will be maximized. You recall that you can use estimated cash flows, weighted average cost of capital (WACC), and the capital asset pricing model (CAPM) to estimate share value. As a first step you found the following information on Yahoo finance:

“The current prime borrowing rate is 5.14% and the current risk-free rate (10 year Malaysia Government bond) is 3.07%. You estimate the market risk premium into the foreseeable future at 8%.

Next, you obtained from a local investment banker the following estimated debt risk premiums and subjective betas for Anjung Puteri at various debt levels:

Scenario	Amount Borrowed (RM)	Debt Risk Premium (%)	Subjective Beta
1	0	2.0	2.0
2	187,500	2.0	2.1
3	375,000	2.5	2.3
4	562,500	3.5	2.5
5	750,000	5.0	2.9
6	937,500	7.0	3.3
7	1,125,000	10.0	3.7

Required:

1. What is the estimated total asset value and total equity value under each debt scenario?

Hint: Total Asset = Earning/WACC

Answer 1

WACC = (Cost of Equity*Weight of Equity )+ (Cost of debt*weight of debt)

Cost of Equity = Risk free rate + Risk Premium* Beta

Risk free Rate = 3.07%

Rsk Premium = 8%

Scenario	Amount Borrowed (RM)	Debt Risk Premium (%)	Subjective Beta
1	-	2	2
2	1,87,500	2	2.1
3	3,75,000	2.5	2.3
4	5,62,500	3.5	2.5
5	7,50,000	5	2.9
6	9,37,500	7	3.3
7	11,25,000	10	3.7

Scenario 1

Cost of Equity = Risk free rate + Risk Premium* Beta

   = 3.07%+8%(2)

   = 19.07%

Under First scenario there is no debt hence Cost of equity = WACC

Therefore Total Assets Value = Earnings / WACC

= 500000/19.07%

   = 2621919.2448

Under Second scenario

Cost of Equity = Risk free rate + Risk Premium* Beta

= 3.07%+8%(2.1)

   =19.87%

Cost of debt = Interest Rate* (1-Tax Rate)

= (Current borrowing rate +risk premium)*(1-Tax Rate)

   = (5.14%+2%)*(1-0.24)

=5.4264%

debt value=187500 Weight of debt = 187500/1500000 = 0.125

Value of Equity = (100000*15)-187500 Weight of Equity = 0.875

   =13,12,500

WACC = 0.125*5.4264% + 0.875*19.87%

= 18.06455 %

Entity VAlue = 500000/18.06455% = RM2767852

Debt VAlue = 187500

SO Equity VAlue = 2767852-187500= 2580352

Following tables can helps for solving problem easily

For Cost of equity

Scenario[1]	Amount Borrowed (RM)[2]	Debt Risk Premium (%)[3]	Subjective Beta[4]	Risk Premium [5]	[4]*[5]	Risk Free rate[6]	Cost of Equity ([4]*[5])+[6]
1	-	2	2	8	16	3.07	19.07
2	1,87,500	2	2.1	8	16.8	3.07	19.87
3	3,75,000	2.5	2.3	8	18.4	3.07	21.47
4	5,62,500	3.5	2.5	8	20	3.07	23.07
5	7,50,000	5	2.9	8	23.2	3.07	26.27
6	9,37,500	7	3.3	8	26.4	3.07	29.47
7	11,25,000	10	3.7	8	29.6	3.07	32.67

For Cost of debt

Scenario[1]	Amount Borrowed (RM)[2]	Debt Risk Premium (%)[3]	Interest Rate[4]	Cost of debt [3]+[4]	[5]	Effective cost of debt [3]+[4]*[5]
1	-	2	0	0	0	0
2	1,87,500	2	5.14	7.14	0.76	5.4264
3	3,75,000	2.5	5.14	7.64	0.76	5.8064
4	5,62,500	3.5	5.14	8.64	0.76	6.5664
5	7,50,000	5	5.14	10.14	0.76	7.7064
6	9,37,500	7	5.14	12.14	0.76	9.2264
7	11,25,000	10	5.14	15.14	0.76	11.5064

For WACC

Scenario[1]	Amount Borrowed (RM)[2]	Equity Value (150000-[2])	Debt Weight ([2]/1500000)=[3]	Equity Weight (1-[3])=[4]	Cost of debt[5]	Cost of Equity[6]	WACC ([3]*[5] + [4]*[6])
1	-	0	0	0	0	0	NA
2	1,87,500	13,12,500	0.125	0.875	5.4264	19.87	18.06455
3	3,75,000	11,25,000	0.25	0.75	5.8064	21.47	17.5541
4	5,62,500	9,37,500	0.375	0.625	6.5664	23.07	16.88115
5	7,50,000	7,50,000	0.5	0.5	7.7064	26.27	16.9882
6	9,37,500	5,62,500	0.625	0.375	9.2264	29.47	16.81775
7	11,25,000	3,75,000	0.75	0.25	11.5064	32.67	16.7973

For Entity value and equity VAlue

Scenario[1]	Amount Borrowed (RM)[2]	WACC	Earnings	Value of entity= Earnings/WACC	Value of equity=Value of entity-Value of debt borrowed
1	-	NA	500000	NA	NA
2	1,87,500	18.06%	500000	2767852	25,80,352
3	3,75,000	17.55%	500000	2848337	24,73,337
4	5,62,500	16.88%	500000	2961884	23,99,384
5	7,50,000	16.99%	500000	2943211	21,93,211
6	9,37,500	16.82%	500000	2973049	20,35,549
7	11,25,000	16.80%	500000	2976669	18,51,669