Capital Structure Theories

The following scenario relates to Q46-50.

A meeting was conducted by the board of directors of Brocade Co to discuss the balance of equity & debt financing. The following statements were made by the directors:

• Director A: We should keep our weighted average cost of capital at the lowest by keeping the optimum balance of gearing.
• Director B: The Company is placed in a perfect market & no need to consider the balance of equity & debt.
• Director C: We should finance the whole operations using only debt sources of finance to gain tax reliefs.
• Director D: We should choose debt or equity sources of financing only if retained profits are insufficient or unavailable.

Q46. Which director seems to support Pecking order theory? (MCQ)

• Director A
• Director B
• Director C
• Director D
  (2 marks)

Q47. Director A’s statement is applying which theory? (MCQ)

• Traditional Theory
• M;M Theory 1958
• Pecking Order Theory
• M;M Theory 1963 tax
  (2 marks)

Q48. Which of the following directors seems to have a risk of tax exhaustion? (MCQ)

• Director A
• Director B
• Director C
• Director D
  (2 marks)

Q49. Which of the following director thinks to offset the increased cost of equity with benefit gained on debt? (MCQ)

• Director A
• Director B
• Director C
• Director D
  (2 marks)

Q50. Which of the following statements is incorrect? (MCQ)

• Equity financing is costly as compared to loans
• A bank is at low risk as they are secured by mortgages
• Cost of capital is decreased if the market value of the company rises
• The company receives no tax benefits
  (2 marks)

WACC (BASIC) ; RISK ADJUSTED WACC

The following scenario relates to Q51-55.

Fasces’ Co is a listed company. It is wholly financed using equity & its shares are bought by financial intermediaries. Recently, a finance director was replaced as the previous director was relocated to another country. The new director wants to apply capital asset pricing model to assess risk & include stock market reactions. The finance director has done some research which is as follows:

The Risk-free return 3% per annum
The Return of government securities 12% per annum
Hearses Co (Competitor) 0.8 Equity Beta

Q51. Calculate the return on equity of Hearses Co? (MCQ)

• 3%
• 9.6%
• 10.2%
• 32%
  (2 marks)

Q52. The annual return on equity is assumed to be 22%. Calculate the equity beta of Fasces’ Co? (MCQ)

• 2.1%
• 3.7%
• 17.6%
• 22%
  (2 marks)

Q53. Which of the following statements are true? (MRQ)

• The beta of Fasces’ Co is indicating an unsystematic risk
• Fasces’ Co will like to obtain a return greater than the government securities
• The return obtained will be determined using unsystematic risk
• If Fasces’ Co share price increases, then equity beta will also increase
  (2 marks)

Q54. Fasces’ Co paid an interim dividend of 35c/share. The share price increase by 20% to $5.4/share. What is the total shareholder return (to the nearest %)? (FIB)
596901651000%
(2 marks)

Q55. Fasces’ Co is a garment business. Which of the following circumstances will the company use its own WACC? (MCQ)

• Buying its competitor’s business
• Buying a shoe manufacturer
• Buying a retailer shop
• Buying a supermarket
  (2 marks)

The following scenario relates to Q56-60.

Gruber Co is stock exchange listed company has issued 100 million shares in the market. The current share price is $2.65/share. Gruber Co also issued bonds having a book value of $60 million. The current market price is $104/$100 bonds. The cost of debt for the company is 9% with paying a corporation tax of 30%. The dividends have been paid as follows:
Year 2010 2011 2012 2013 2014
DPS ($) 0.19 0.2 0.25 0.3 0.32

Q56. Calculate the cost of equity of Gruber Co? (MCQ)

• 13.9%
• 15.4%
• 27.6%
• 29.1%
  (2 marks)

Q57. Calculate the WACC? (MCQ)

• 9%
• 11%
• 17.9%
• 24%
  (2 marks)

Q58. The company is issuing bonds worth $40 million at par. These would pay an interest before tax of 8% ; will be redeemed at 5 % premium after ten years. Calculate the cost of debt? (MCQ)

• 5%
• 6.17%
• 10.45%
• 11%
  (2 marks)

Q59. The market value of equity is $250 ; the cost is 13%. The cost of debt is 9% ; the market value is $50. Calculate the WACC including the information of Q58? (MCQ)

• 8.2%
• 10.9%
• 11.6%
• 12.3%
  (2 marks)

Q60. Which of the following factors would likely affect the market value of a bond? (MRQ)

• The frequency of interest payments
• The redemption value of the bond
• The time duration of repayment
• The amount of interest repayable
  (2 marks)

The following scenario relates to Q61-65.

Nastic Co has in issue ten million ordinary shares each having a current market value of $7.5. The company has 7% bonds at par value. The bonds are redeemable in seven years at par. The bonds are currently trading at $112/bond. The total nominal value sits at $14,000,000. Nastic Co equity beta is 0.7. The risk-free rate is 5% per annum ; average return in the market is 13% per annum.

Nastic Co wants to diversify his business opportunities ; are thinking to invest in the same industry. A potential company has been seen bidding for Bracey Co. Its equity to debt ratio in the market is 75% to 25%. The equity beta is 1.6.
Both companies are subject to pay a corporation tax of 20%

Q61. Calculate the cost of debt? (MCQ)

• 3.29%
• 4.27%
• 9.1%
• 10.3%
  (2 marks)

Q62. Cost of the equity of 11% is assumed. What will be the weighted cost of capital? (MCQ)

• 3.8%
• 5.21%
• 8.24%
• 9.7%
  (2 marks)

Q63. Calculate the risk-adjusted beta? (MCQ)

• 1.2 Beta
• 1.37 Beta
• 1.74 Beta
• 2.1 Beta
  (2 marks)

Q64. Calculate the risk-adjusted cost of equity? (FIB)

• 596901968500%
  (2 marks)

Q65. Which of the following is not a disadvantage of CAPM? (MCQ)

• Differentiation in capital gains ; dividends are ignored
• The return of the market is incorporated
• It assumes that all shareholders are diversified
• Beta factors might be inaccurate
  (2 marks)

ANSWERS

• Q46. D
• Q47. A
• Q48. C
• Q49. B
• Q50. D

The company receives a tax benefit on their interest payments.

Q51. C

• Use CAPM formulae
• Ke = 3 + (12 – 3) 0.8 = 10.2%

Q52. A

• Use CAPM formulae
• Ke = 3 + (12 – 3) X = 22
• X = 2.1%

Q53.

• The beta of Fasces’ Co is indicating an unsystematic risk (False)
• Fasces’ Co will like to obtain a return greater than the government securities (True)
• The return obtained will be determined using unsystematic risk (False)
• If Fasces’ Co share price increases, then equity beta will also increase (True)
• The equity beta measures the changes in the return of share price. The return will be determined by using systematic risk as unsystematic risk is diversifiable.

Q54. 28%

• Total shareholder return = [(5.4 – 4.5) + 0.35] ÷ 4.5 =0.2777
  0.2777 × 100 = 27.7%

Q55. A

• An investing company can use its own WACC only when its business risk & financial risk remains same. In the case of buying its competitor, its business risk & financial risk will remain same. All other option will change the business risk and will have to use risk-adjusted WACC.

Q56. C

• g = [(0.32 ÷ 0.19) 1 ÷ (5-1) – 1] × 100 = 13.9%
• D1 = (0.32 × (1 + 13.9%) = 0.364
• Ke = [(0.364 ÷ 2.65) + 13.9%] × 100 = 27.6%

Q57. D

• ($m) ($m)
• Equity 100 × 2.65 265 × 27.6% 73.14
• Debt (60 ÷ 100) × 104 62.4 ×9% 5.616
• Total 327.4 78.756
• WACC = (78.756 ÷ 327.4) × 100 = 24%

Q58. B

• Year Cash flow ($) DF (5%) Present value ($) DF (10%) Present Value ($)
• MV/Bond 0 (100) 1 (100) 1 (100)
• Interest 1-10 5.6 7.72 43.23 6.14 34.38
• Redeem 10 105 0.614 64.47 0.386 40.53
• NPV 7.7 (25.09)
• Redemption= 100 × 105% = 105
• IRR = 5 + [7.7 ÷ (7.7 – (-25.09)] × (10 – 5) = 6.17%

Q59. C

• ($m) ($m)
• Equity 250 250 × 13% 32.5
• Debt 50 50 × 9% 4.5
• Debt (Bonds) (40 ÷ 100) × 100 40 × 6.17% 2.468
• Total 340 39.468
• WACC = (39.468 ÷ 340) × 100 = 11.6%

Q60. All options are correct.

Q61. A

• Year Cash flow ($) DF (5%) Present value ($) DF (10%) Present Value ($)
• MV/Bond 0 (112) 1 (112) 1 (112)
• Interest 1-7 5.6 5.786 32.4 4.868 27.3
• Redeem 7 100 0.711 71.1 0.513 51.3
• NPV (8.5) (33.4)
• IRR = 5 + [-8.5 ÷ (-8.5 – (-33.4)] × (10 – 5) = 3.29%

Q62. D

• ($m) ($m)
• Equity 10 × 7.5 75 × 11% 8.25
• Debt (14 ÷ 100) × 112 15.68 ×3.29% 0.516
• Total 90.68 8.766
• WACC = (8.766 ÷ 90.68) × 100 = 9.7%

Q63. C

• Ba = [75 ÷ (75 + 15.68 × {1-20%})] × 1.6 = 1.37
  1.37 = [75 ÷ (75 + 25 × {1-20%})] × BeBe = 1.74

Q64. 18.92%

• Ke = 5 + (13-5) × (1.74) = 18.92%

Q65. B