Financial Management:

Exercises Topic 9
University of Technology, Sydney
UTS Business School – Finance

UTS CRICOS 00099F

Exercise 1
Mars Ltd. has debt with a market value of $30 million (D) and equity with a market value of $70 million (E).
Its pre-tax cost of debt and its cost of equity are 4% p.a. and 8% p.a., respectively. Calculate the firm’s
WACC, if it pays tax at 30%.

Unpacking the information:

Ø Market value of debt is $30 million and of equity if $70 million
Ø Market return on Debt before taxes: RD = 4%
Ø Market return Equity: RE = 8%
Ø Tax rate: Tc= 30%

Ø Value of firm: V = D + E = 30 + 70 = 100 million

Ø WACC = (D ⁄ V) × RD × (1 − Tc) + (E ⁄ V) × RE = 30/100 (0.04 x 0.7) + 70/100(0.08) = 0.0644 or 6.44%

Financial Management
Exercises Topic 9
Exercise 2
Merck & Co. has equity with a book value of $10.5 million and debt with a book value of $2 million. Its
equity consists of 1.13 million shares trading at $32 per share and its debt consists of 10-year bonds that
were originally issued at par and pay an annual coupon of $160,000. Merck’s bonds currently trade at a
premium of 0.2% above the 10-year government bond yield of 6.25% p.a. Its shares have a beta of 1.1
and the equity risk premium is 5.5% p.a.. Answer the following questions, given that the firm pays tax at
30%.

(a) What is the market value of the firm’s debt?

Ø Face Value of bond (issued at par) = $2 million
Ø Coupon of $160,000 paid annually & 10 years to maturity
Ø Market yield on debt is Govt Bond + 0.2%: 6.25% + 0.2% = 6.45%
Ø Solve for the price of a bond (PV = PMT × [(1 − (1 + i)-n) ÷ i] + FV × (1 + i)-n)
Ø PV = 160,000 × [(1 − (1.0645)-10) ÷ 0.0645] + 2,000,000 × (1.0645)-10 = $2,223,376

Financial Management
Exercises Topic 9
Exercise 2
(b) What is the firm’s cost of equity?
Ø As given a beta and nothing on dividends it’s a CAPM problem: E(RE) = Rf + 𝛽 × (E(RM) − Rf)
Ø Rf is the Govt Bond rate = 6.25%
Ø Beta is 1.1
Ø Risk premium (E(RM) − Rf) = 5.5%

Ø E(RE) = Rf + 𝛽 × (E(RM) − Rf) = 0.0625 + 1.1 × 0.055 = 0.123 or 12.3%

Financial Management
Exercises Topic 9
Exercise 2
(c) What is the firm’s WACC?

WACC = (D ⁄ V) × RD × (1 − Tc) + (E ⁄ V) × RE

Ø First we need to calculate the market value of the firm’s equity: the share price is $32 and there are
1.13 million shares on issue. Therefore, the market value of equity is E = 1,130,000 x 32 = $36,160,000
Ø Market value of is debt is D = $ 2,223,376
Ø Market value of the firm: V = D + E = 2.223 + 36.160 = $38.383 million

Ø We have now everything we need to calculate the WACC: WACC = (D ⁄ V) × RD × (1 − Tc) + (E ⁄ V) × RE

WACC = (2.223/38.383) × 0.0645(1 − 0.3) + (36.16/38.383)0.123 = 0.1185 or 11.85%

Financial Management
Exercises Topic 9
Exercise 3
Susan Fashions is expanding and needs to work out her cost of capital to evaluate several different
proposals. Susan Fashions has obtained the following information. Long term debt is an issue of long term
bonds that have $10million face value and a 4% coupon rate paid half yearly. Each bond has a face value
of $100,000 and has seven years to maturity. The last sale of a bond was at a yield of 4.8%pa. Susan
Fashions’ preference shares are trading on the share market at $5.60 a share, below their $10 par value.
The preference share issue was a 5%, $10 non-redeemable preference share. The last sale of Susan
Fashions’ ordinary shares was at $0.90. The beta of Susan Fashions has been calculated at 1.5,
Government bonds are selling in the market at 3.5 %pa and the expected return on the market portfolio is
13%pa. Given that Susan Fashions has a target capital structure of 35% Debt, 20% Preference shares
and Ordinary shares being the balance of financing, Answer the questions below to help Susan work out
her weighted average cost of capital if Susan pays tax at 30%:
(a) What is the market value of the firm’s debt?
(b) What is the firm’s cost of equity?
(c) What is the cost of the firm’s preference share?
(d) What is the firm’s WACC?

Financial Management
Exercises Topic 9
Exercise 3
(a) What is the market value of the firm’s debt?
Ø Face Value of bond (issued at par) = $10 million & 7 years to maturity (14 periods)
Ø Coupon $10,000,000 x 4% / 2 = 200,000 paid half yearly
Ø Market yield on Susan’s debt 4.8% / 2 = 2.4%

Solving for the price of a bond: PV = PMT × [(1 − (1 + i)-n) ÷ i] + FV × (1 + i)-n

PV = 200,000 × [(1 − (1.024)-14) ÷ 0.024] + 10,000,000 × (1.024)-14 = $9,529,108

(b) What is the firm’s cost of equity?

Ø Rf is the long term treasury rate = 3.5%
Ø Beta is 1.5
Ø Return on the market E(RM) = 13%
Ø E(RE) = 0.035 + 1.5 × (0.13 -0.035) = 0.1775 = 17.75%
Financial Management
Exercises Topic 9
Exercise 3
(c) What is the cost of the firm’s preference share?
Ø We use the constant dividend model RP = D1 ÷ P0
Ø Paying a dividend of 5% of $10 = 0.50
Ø Preference share trading in the market at $5.60
Ø RP = D1 ÷ P0 = 0.50 ÷ 5.60 = 0.0893 or 8.93%

(d) What is the firm’s WACC?

Ø 35% of debt, 20% of preference shares. Therefore: Ordinary shares: 100 - (35 + 20) = 45%
Ø RD = 4.8%; RE = 17.75%; RP = 8.93%; Tc = 30%

Ø WACC = (D ⁄ V) × RD × (1 − Tc) + (E ⁄ V) × RE +(P ⁄ V) × Rp

Ø WACC = (0.35) × 0.048(1−0.3) + (0.45)0.1775 + (0.20)0.0893 = 0.1095 or 10.95%

Financial Management
Exercises Topic 9
Exercise 4
Fastrack Ltd. is a transportation company wanting to know if they should proceed with a particular
investment. They have extracted some information from their balance sheet and also provided some other
relevant data. Their target capital structure is debt 27%, preference shares 15%. The tax rate is 30%.
Answer the following questions.
(a) What is the market value of the firm’s debt given bonds have a face value of $2m and 9%pa coupon,
paid annually, maturing in 6 years. Yield to maturity is 7% pa.
(b) What is the cost of the firm’s preference share? Perpetual preference shares of $1m (dividend rate of
12% pa of $5 face value, paid annually in arrears). The preference shares are currently trading at $6.70
each.
(c) What is the firm’s cost of equity? Currently there are 2 million Ordinary shares on issue. Next year's
dividend is expected to be $0.50. The current return on the market is 15% and the market risk premium is
6%. Fastrack's beta is 1.4.
(d) What is the firm’s WACC?

Financial Management
Exercises Topic 9
Exercise 4
(a) What is the market value of the firm’s debt given bonds have a face value of $2m and 9%pa coupon,
paid annually, maturing in 6 years. Yield to maturity is 7% pa.
Ø Cost of debt (Rd) = 7%
Ø Coupon PMT = 2,000,000 x 9% = 180,000
Ø PV = PMT × [(1 − (1 + i)-n) ÷ i] + FV × (1 + i)-n = 180,000 × [(1 − (1.07)-6) ÷ 0.07] + 2,000,000 × (1.07)-6
Ø PV = $2,190,662

(b) What is the cost of the firm’s preference share? Perpetual preference shares of $1m (dividend rate of
12% pa of $5 face value, paid annually in arrears). The preference shares are currently trading at $6.70
each.
Ø Paying a dividend of 12% of $5 = 0.60
Ø Preference share trading in the market at $6.70
Ø RP = D1 ÷ P0 = 0.60 ÷ 6.70 = 0.0895 or 8.95%

Financial Management
Exercises Topic 9
Exercise 4
(c) What is the firm’s cost of equity? Currently there are 2 million Ordinary shares on issue. Next year's
dividend is expected to be $0.50. The current return on the market is 15% and the market risk premium is
6%. Fastrack's beta is 1.4.
Ø Risk premium = (E(RM) − Rf) à Rf = E(RM) – Risk Premium = 15% - 6% = 9%
Ø Given: Rm = 15%; Rm – Rf = 6%; Rf = 9%
Ø E(RE) = Rf + 𝛽 × (E(RM) − Rf) = 0.09 + 1.4 × 0.06 = 0.174 or 17.4%

(d) What is the firm’s WACC?

Ø 27% debt, 15% preference shares. Therefore: Ordinary shares 100 - (27 + 15)= 58%
Ø RD= 7%; RE=17.4%; RP = 8.95%; Tc = 30%
Ø WACC = (D ⁄ V) × RD × (1 − Tc) + (E ⁄ V) × RE +(P ⁄ V) × Rp
Ø WACC = (0.27) × 0.07(1−0.3) + (0.58)0.174 + (0.15)0.0895 = 0.1276 or 12.76%

Financial Management
Exercises Topic 9
Exercise 5
A firm has a current capital structure consisting of $1,400,000 of 9% (annual interest) debt and 500,000
ordinary shares. The firm’s tax rate is 30%. If EBIT is expected to be $1,200,000, calculate the firm’s
Earnings Per Share.
Ø Interest (I) = 1,400,000 x 0.09 = $126,000
Ø Number of shares = 500,000

EPS =
( EBIT - I) x (1 - T )
=
( 1,200,000 - 126,000 ) x (1 - 0.3)
= $1.50
Number of shares 500,000

Financial Management
Exercises Topic 9
Exercise 6
ABC Ltd. produces markers with a sale price of $20 per unit. Fixed costs are $50,000 per year, variable
costs are $12 per unit and annual depreciation is $10,000. The firm’s capital is made up of 40% debt and
60% equity, with the latter taking the form of 10,000 ordinary shares. ABC’s assets are valued at $100,000
and it pays interest of 6% per annum on its debt. Answer the following questions, given that ABC’s tax rate
is 30% and the firm is able to claim the full tax benefit of any loss. Calculate the firm’s EBIT and EPS if it
sells 20,000 markers per year
Sales (20,000x$20) 400000 Ø Number of shares on issue:10,000
Variable costs (20,000x$12) -240000
Ø EBIT = 100,000
Fixed cost -50000
EPS = profit after tax / # shares
Deprecation -10000
EBIT 100000 EPS = $68,320 / 10,000
Interest 6%x$40,000 -2400 = $6.83
profit before tax 97600
tax @30% -29280
profit after tax 68320

Financial Management
Exercises Topic 9
Exercise 7
Willow & Co. produces and installs designer kitchen fittings and has EBIT of $1.5 million. Its capital
consists of $12 million in ordinary shares and $9 million in long-term debt. There are 6,000 shares
outstanding and the interest rate on the firm’s debt is 6% p.a. Following a review of the firm’s capital
structure, the CFO has concluded that the level of financial risk is too high. She has recommended that the
firm’s debt-to-equity ratio should be reduced from its current level of 75% to a more sustainable level of
50%. This would involve issuing additional equity of $2 million, which would be used to retire an
equivalent amount of debt. Answer the following questions, given that the firm pays tax at 30%.
(A) How many additional shares would Willow have to issue, in order to obtain the desired debt-to-equity
ratio, if the shares were issued at the price implied by the value of its equity?
(B) What is the breakeven EBIT where the proposed new capital structure delivers the same EPS as the
existing capital structure?
(C) At an EBIT of $1,500,000 which structure should Willow use?

Financial Management
Exercises Topic 9
Exercise 7
(A) How many additional shares would Willow have to issue, in order to obtain the desired debt-to-equity
ratio, if the shares were issued at the price implied by the value of its equity?

Ø Shares currently worth $12 million and there are 6000 shares on issue

Ø Market value of one share 12,000,000 / 6000 = $2,000 each,

Ø To raise $2 million, the firm would have to issue $2,000,000 / $2,000 = 1000 new shares.

Note that:

Ø Willow’s new capital would be $14 million equity

Ø Debt is $9 million now. After share issue debt = $9 – $2 = $7 mill

Ø Debt to equity ratio = 7/14 = 50%

Financial Management
Exercises Topic 9
Exercise 7
(B) What is the breakeven EBIT where the proposed new capital structure delivers the same EPS as the
existing capital structure?

EPS = [(EBIT − INT) × (1 − Tc) − PREFDIV] ÷ S

Ø Annual interest under current capital structure is 0.06 x $9mill = $0.54 million ß INT1
Ø Number of shares under current structure = 6,000 ß S1

Ø Current EPS: EPS1 = [(EBIT − 540,000) × (1 − 0.3)] ÷ 6,000

Ø Annual interest under new capital structure would be 0.06 x $7mill = $0.42 million ß INT2
Ø Number of shares under new structure: 6,000 + 1,000 = 7,000 ß S2
Ø Proposed EPS: EPS2 = [(EBIT − 420,000) × (1 − 0.3)] ÷ 7,000
Ø To calculate Breakeven point, equate EPS1 to EPS2 and solve the equations for EBIT:
[(EBIT − 540,000) × (1 − 0.3)] ÷ 6,000 = [(EBIT − 420,000) × (1 − 0.3)] ÷ 7,000
Financial Management
Exercises Topic 9
Exercise 7
[(EBIT − 540,000) × (1 − 0.3)] ÷ 6,000 = [(EBIT − 420,000) × (1 − 0.3)] ÷ 7,000
• Divide both sides by (1-0.3):
(EBIT − 540,000) ÷ 6,000 = (EBIT − 420,000) ÷ 7,000
• Multiply both sides by 6,000 and 7,000:
(EBIT − 540,000) × 7,000 = (EBIT − 420,000) x 6,000
• Divide by 1,000 and multiple out by 7 and 6:
7EBIT − 3,780,000 = 6EBIT − 2,520,000
• Subtract 6EBIT and add 3,780,000 to both sides:
7EBIT - 6EBIT = 3,780,000 – 2,520,000

EBIT = $1,260,000

Financial Management
Exercises Topic 9
Exercise 7
(C) At an EBIT of $1,500,000 which structure should Willow use?
Ø As the Break even point is below the EBIT of $1,500,000 stay with existing structure

Current Proposed
EBIT 1,500,000 1,500,000
Interest -540,000 -420,000
PBT 960,000 1,080,000
Tax 288,000 324,000
PAT 672,000 756,000
#shares 6000 7000
EPS 112 108

Financial Management
Exercises Topic 9
Exercise 8
Cross City Tunnel (CCT) Ltd currently has 5 million shares on issue with a market price of $2.50 each.
CCT also has $7 million of debt. The Chief Financial Offer is considering changing the capital structure by
borrowing $3 million of debt and using the funds raised to buy back equity. The interest rate on debt is10%
p.a. and the company tax rate is 30%. Calculate EPS for both the current and the proposed capital
structures at a projected EBIT level of$3.7 million. Which capital structure is preferable if this is the
expected level of EBIT?
Ø Currently 5 million shares (S1) - market price of $2.50 each à E1 = 5,000,000 x 2.5 = 12,500,000
Ø Will buy back $3 million of equity at a share price of $2.50.
• Shares to buy back: $3,000,000/ $2.50 = 1,200,000 shares.
Ø Under new plan 5,000,000 - 1,200,000 = 3,800,000 shares on issue (S2)
Ø Currently $7,000,000 of debt at 10% interest rate
• Current interest 7,000,000x 10% = 700,000
Ø New plan $10,000,000 of debt at 10% interest rate
• Current interest 10,000,000x 10% = 1,000,000

Financial Management
Exercises Topic 9
Exercise 8

current proposed
EBIT 3,700,000 3,700,000
Interest -700,000 -1,000,000
PBT 3,000,000 2,700,000
Tax -900,000 -810,000
PAT 2,100,000 1,890,000
No Shares 5,000,000 3,800,000
EPS 0.42 0.49737

Ø The preferable capital structure is that of the proposed project given that it has a higher EPS

Financial Management
Exercises Topic 9