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    Solution: Part (A)

    Uploaded by

    Ahmed Raza Mir
    The document analyzes different capital structures for a company and calculates the weighted average cost of capital (WACC) for each. It considers financing 100% through debt, 50% debt and 50% equity, and the existing structure of 60% debt and 40% equity. Financing entirely through debt results in the lowest WACC of 16.5% and highest earnings per share. A 50-50 structure has a WACC of 17.58%. The existing structure has the highest WACC of 18.22%.

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    Solution: Part (A)

    Uploaded by

    Ahmed Raza Mir
    17 views12 pages
    The document analyzes different capital structures for a company and calculates the weighted average cost of capital (WACC) for each. It considers financing 100% through debt, 50% debt and 50% equity, and the existing structure of 60% debt and 40% equity. Financing entirely through debt results in the lowest WACC of 16.5% and highest earnings per share. A 50-50 structure has a WACC of 17.58%. The existing structure has the highest WACC of 18.22%.

    Original Description:

    Solu

    Original Title

    Winter 2013

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    The document analyzes different capital structures for a company and calculates the weighted average cost of capital (WACC) for each. It considers financing 100% through debt, 50% debt and 50% equity, and the existing structure of 60% debt and 40% equity. Financing entirely through debt results in the lowest WACC of 16.5% and highest earnings per share. A 50-50 structure has a WACC of 17.58%. The existing structure has the highest WACC of 18.22%.

    Copyright:

    © All Rights Reserved
    Download as XLSX, PDF, TXT or read online from Scribd
    Download as xlsx, pdf, or txt
    17 views12 pages

    Solution: Part (A)

    Uploaded by

    Ahmed Raza Mir
    The document analyzes different capital structures for a company and calculates the weighted average cost of capital (WACC) for each. It considers financing 100% through debt, 50% debt and 50% equity, and the existing structure of 60% debt and 40% equity. Financing entirely through debt results in the lowest WACC of 16.5% and highest earnings per share. A 50-50 structure has a WACC of 17.58%. The existing structure has the highest WACC of 18.22%.

    Copyright:

    © All Rights Reserved
    Download as XLSX, PDF, TXT or read online from Scribd
    Download as xlsx, pdf, or txt
    of 12

    Solution

    Part (a)
    As per prudential Regulations The borrowing capacity is worked out using
    book values
    Book Value of Equity
    Dividend to be paid
    Ex-Div Value of Equity
    Debt to equity ratio
    i.e.
    Debt Equity Ratio

    1,663
    (225)
    1,438
    60%:40%
    Rs 1.5 Debt to Re 1 Equity
    1.50

    Debt Capacity
    Existing
    Further borrowing Capacity

    2,157
    (526)
    1,631

    The company needs Rs 1,500 million for the project which can be
    raised within the borrowing limits available as at the reporting date
    without injecting any equity.
    Part (b)
    Weighted Average Cost of Capital
    Market Value of Equity
    Cost of Equity (ke)
    Market value of Debt
    Cost of Debt (before tax) (Kd)

    Rs
    Rs

    WACC

    18.22%

    Market Value of Equity


    Cum dividend Value
    Dividend per share
    Ex-Dividend Value

    2,025
    20%
    515
    15.40%

    Per share
    30
    (3)
    27

    Cost of debt will be the irr incorporating the market values of debt
    Interpolation
    Yr

    CF
    1
    2
    3
    4
    5
    6

    (98)
    7
    7
    7
    7
    7
    107

    Internal rate of Return (Kd)


    Effective Annual Rate (Before Tax)

    7.43%
    15.40%

    Market Returns (Rm)


    At start of last yr
    At end of last yr

    15,530
    18,325

    Change

    18.00%

    Beta Debt
    Since the bond is a corporate bond so its not risk free and risk of issued debt is
    gauged in its beta
    Premium for risk (as compared to Sovrn bonds)
    Market premium for investing in market
    Ratio of premiums (Beta Debt)
    Cost of Equity
    We know that

    Beta Asset = {Be x E/(E + After tax D) + (Bd x after tax D / (E + After tax D)
    and
    Beta Equity = {Beta Asset - (Bd x after tax D / (E + After tax D)} x {(E + After tax D)/
    Beta Asset
    Beta Debt

    1.20
    0.63

    Debt
    Equity
    Beta Equity

    515.48
    2,025.00
    1.3017

    Working for Beta Equity


    (Bd x after tax D / (E + After tax D)
    {Beta Asset - (Bd x after tax D / (E + After tax D)}
    {(E + After tax D)/E}
    Beta Equity
    Cost of Equity
    Risk free rate on Gov Bonds
    Market risk premium
    Beta Equity
    Cost of Equity

    0.0951
    1.1049
    1.1782
    1.3017

    11%
    7.0%
    1.30
    20.11%

    Note
    Company's existing WACC should be calculated using market values not the book
    values. The suggested solution (previously available) was made using book values.
    Part (a) of the question specifically referred the prudential regulations and hence it
    was solved using book values. No such reference was made for part (b).
    Furthermore, Calculation of WACC using book values will not produce any
    meaningful information a compared to its calculation using market values.
    Part (C)
    Financing 100% through debt
    Weighted Average Cost of Capital
    Market Value of Equity ('E)
    Cost of Equity (ke)
    Market value of Debt (D)
    Cost of Debt (before tax) (Kd)
    WACC

    Rs
    Rs

    2,025
    21%
    2,015
    17.40%

    Unchanged (no issuance


    (Changed due to change
    Changed due to issuance
    Changed due to change i

    16.50%

    Beta Debt
    Since the bond is a corporate bond so its not risk free and risk of issued debt is

    gauged in its beta


    Premium for risk (as compared to Sovrn bonds)
    Market premium for investing in market
    Ratio of premiums (Beta Debt)
    Cost of Equity
    We know that

    Beta Asset = {Be x E/(E + After tax D) + (Bd x after tax D / (E + After tax D)
    and
    Beta Equity = {Beta Asset - (Bd x after tax D / (E + After tax D)} x {(E + After tax D)/
    Beta Asset
    Beta Debt
    Debt
    Equity
    Beta Equity

    1.20
    0.91
    2,015.48
    2,025.00
    1.3989

    Unchanged
    Changed due to increase in Kd
    Changed due to issuance of further deb
    Unchanged
    Changed due change in weight of Debt

    Working for Beta Equity


    (Bd x after tax D / (E + After tax D)
    {Beta Asset - (Bd x after tax D / (E + After tax D)}
    {(E + After tax D)/E}
    Beta Equity
    Cost of Equity
    Risk free rate on Gov Bonds
    Market risk premium
    Beta Equity
    Cost of Equity

    0.3755
    0.8245
    1.6967
    1.3989

    11%
    7.0%
    1.40
    20.79%

    Financing 50% through debt and 50% through equity


    Weighted Average Cost of Capital
    Market Value of Equity ('E)
    Cost of Equity (ke)

    Rs

    2,775 Changed (due to issuance


    20% (Changed due to change

    Market value of Debt (D)


    Cost of Debt (before tax) (Kd)

    Rs

    1,265 Changed due to issuance


    16.40% Changed due to change i

    WACC

    17.58%

    Beta Debt
    Since the bond is a corporate bond so its not risk free and risk of issued debt is
    gauged in its beta
    Premium for risk (as compared to Sovrn bonds)
    Market premium for investing in market
    Ratio of premiums (Beta Debt)
    Cost of Equity
    We know that

    Beta Asset = {Be x E/(E + After tax D) + (Bd x after tax D / (E + After tax D)
    and
    Beta Equity = {Beta Asset - (Bd x after tax D / (E + After tax D)} x {(E + After tax D)/
    Beta Asset
    Beta Debt
    Debt
    Equity
    Beta Equity

    1.20
    0.77
    1,265.48
    2,775.00
    1.3367

    Unchanged
    Changed due to increase in Kd
    Changed due to issuance of further deb
    Unchanged
    Changed due change in weight of Debt

    Working for Beta Equity


    (Bd x after tax D / (E + After tax D)
    {Beta Asset - (Bd x after tax D / (E + After tax D)}
    {(E + After tax D)/E}
    Beta Equity
    Cost of Equity
    Risk free rate on Gov Bonds
    Market risk premium
    Beta Equity
    Cost of Equity

    11%
    7.0%
    1.34
    20.36%

    0.1867
    1.0133
    1.3192
    1.3367

    Evaluation
    Profit before interest and tax
    Finance cost
    Profit before tax
    Tax
    Profit after tax

    Existing
    Option 1
    532
    857
    (80)
    (351)
    452
    506
    (136)
    (152)
    316
    354

    Shares

    82.50

    82.50

    EPS

    3.835

    4.296

    18.22%

    16.50%

    WACC

    out using

    issued debt is

    4.40%
    7.00%
    0.6290

    After tax D)
    x {(E + After tax D)/E}

    ues not the book


    using book values.
    tions and hence it

    duce any
    et values.

    hanged (no issuance of shares)


    nged due to change in financial risk)
    nged due to issuance of Debt
    nged due to change in financial risk

    issued debt is

    6.40%
    7.00%
    0.9145

    After tax D)
    x {(E + After tax D)/E}

    ncrease in Kd
    suance of further debt

    nge in weight of Debt in capital structure

    nged (due to issuance of shares)


    nged due to change in financial risk)

    nged due to issuance of Debt


    nged due to change in financial risk

    issued debt is

    5.40%
    7.00%
    0.7717

    After tax D)
    x {(E + After tax D)/E}

    ncrease in Kd
    suance of further debt

    nge in weight of Debt in capital structure

    Option 2
    857
    (208)
    649
    (195)
    455
    110
    4.122
    17.58%

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