Scribd
Upload
134 views

Tutorial 4 Questions

This document contains tutorial questions on capital structure theories and a weighted average cost of capital (WACC) calculation problem. It also includes a problem estimating the beta of a company's investment in a hockey team using its equity holdings in another company. The trade-off and pecking order theories of capital structure are discussed, as well as the costs of financial distress. The tutorial questions explore these concepts and calculating WACC based on capital structure.

Uploaded by

hrfjbjrfrf
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
134 views

Tutorial 4 Questions

This document contains tutorial questions on capital structure theories and a weighted average cost of capital (WACC) calculation problem. It also includes a problem estimating the beta of a company's investment in a hockey team using its equity holdings in another company. The trade-off and pecking order theories of capital structure are discussed, as well as the costs of financial distress. The tutorial questions explore these concepts and calculating WACC based on capital structure.

Uploaded by

hrfjbjrfrf
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
You are on page 1/ 3

Tutorial 4

Questions

1. Discuss the trade-off theory of capital structure.


2. Discuss the costs / signs of financial distress in a firm.
3. Explain the pecking order theory of capital structure.
4. Discuss the usefulness of pecking order theory.
5. It is argued that cost of equity is always greater than cost of debt. Discuss.

Problems

1. You would like to estimate the weighted average cost of capital for a new airline business.
Based on its industry asset beta, you have already estimated an unlevered cost of capital for
the firm of 9%. However, the new business will be 25% debt financed, and you anticipate its
debt cost of capital will be 6%. If its corporate tax rate is 40%, what is your estimate of its
WACC?

Vd= 25%
VE= 75%
Kd= 6%
T= 40%
Unlevered cost of equity= 9 %

(1) Unlevered cost of capital


-computing WACC without taking into consideration of tax effect
WACC= KE (VE / VE + VD) + Kd (VD/ VE + VD)

(2) Levered cost of capital


-Take into consideration of the tax effect (Tax security / downside effect [bankruptcy
cost / financial distress cost])
WACC= KE (VE / VE + VD) + Kd (VD/ VE + VD) (1-TD)

0.09 =KE (0.75 / 0.25 + 0.75) + 0.06 (0.25/ 0.75 +0.25)


KE= [0.09 - 0.06 (0.25)] / 0.75
= 0.1
= 10%

WACC= 0.1 (0.75) + (1 – 0.40) x 0.06 (0.25)


= 8.4%

Levered cost of capital should always be smaller than unlevered cost of capital
2. Harrison Holdings, Inc. (HHI) is publicly traded company, with a current share price of $32
per share. HHI has 20 million shares outstanding, as well as $64 million in debt. The founder
of HHI, Harry Harrison, made his fortune in the fast food business. He sold off part of his fast-
food empire, and purchased a professional hockey team. HHI’s only assets are the hockey
team, together with 50% of the outstanding shares of Harry’s Hotdogs restaurant chain.
Harry’s Hotdogs (HDG) has a market capitalization of $850 million, and an enterprise value of
$1.05 billion. After a little research, you find that the average asset beta of other fast-food
restaurant chains is 0.75. You also find that the debt of HHI and HDG is highly rated, and so
you decide to estimate the beta of both firms’ debt as zero. Finally, you do a regression
analysis on HHI’s historical stock returns in comparison to the S&P 500, and estimate an
equity beta of 1.33. Given this information, estimate the beta of HHI’s investment in the
hockey team.

HHI HDG Hockey


Share Price, P0 $32
Share Outstanding 20 million
Debt, VD $64 million
MV of equity, Market $32 x 20 M = $640M $850M x 50% = $425M (HHI
capitalization, VE only owns 50%)
MV of debt $64M $1.05B - $850M = $200M
Total MV, VF (Value of the $640M + 64M = $704M $1.05M
firm)
βA 0.75
βD 0** 0**
βE 1.33

P0 = $32

VD HHI = 64M

O/S HHI = 20M

VF HHI = VE HHI + VD HHI

= 640M + 64M

= 704 M

VE = 32 X 20 M

= 640M

VE HDG = $ 850m

VF HDG = 1050 M

= 1.05 B
VD HDG = VF HDG – VE HDG

= 1050 M – 850 M

= 200 M

BA HDG = 0.75

BD HHI= 1.33

β D∗D β E∗E
HI I β A = +
D+ E D+ E
0∗64 1.33∗640
¿ +
704 704
¿ 1.21

β D∗D β E∗E
HDG β A = +
D+ E D+ E
0∗200 β E∗850
0.75= +
1050 1050
HDG β E =0.9 3

V HHI = 50% VE HDG + V HOCKEY TEAM

704M = 425 M + V HOCKEY TEAM

V HOCKEY TEAM = 279 M

MV E , HDG MV E , HOCKEY
β A , HHI = β E , HDG × + β E , HOCKEY
MV HHI MV HHI
425 279
1.21=0.93 × + β E , HOCKEY
704 704
β E , HOCKEY =1.64

You might also like