BF2244: Strategic Finance Worksheet Five

(Lectures: Weeks 9 & 10) (Friday Sessions: Weeks 10 & 11)

1. Quip Plc has 2 million shares in issue currently trading at 3.15. Its only debt is in the form of a 3yr bond with a coupon rate of 9% (face value = 100). The yield to maturity on the bond is 6% and the bonds have a book value of 4.5 million. Corporation tax is 30%. Assuming a return on equity of 14% what is the WACC?

2. Explain what is meant by the equation: VL = VU + DTc. When do you think this equation works best?

3. You are in the perfect world of Modigliani and Miller (so no tax). Cube Plc is 100% equity and equity holders currently expect a return of 20% based on an equity beta of 1.1. Cube is considering replacing 60% of the equity with debt paying 10%. Assuming the debt has a beta of 0.4 a. What would the WACC of the firm be if it goes ahead with its plan? b. What would the cost of equity be if the firm goes ahead with its plan? c. What would be the beta of equity be if the firm goes ahead with its plan?

4. Riff Plc has a WACC of 16%. If the required rates of returns are 22% and 8% on equity and debt respectively, and corporation tax is 40%, then what is Riffs gearing level?

5. What do we mean by the term Financial Distress? Give four examples of indirect costs of financial distress.

6. Assume the current riskless rate is 5% and the market premium is 8%. Sphere Plc is 30% debt, 30% preference shares and 40% equity. Its preference shares have a beta of 0.8 whilst the equity has a beta of 1.2. Ignoring tax, calculate the WACC if; a. The debt is riskless b. The debt has a beta of 0.2

7. What do we mean by the WACC? Why is it important for firms? How does finance theory say WACC might vary with capital structure? If increasing levels of debt can increase both the cost of debt and the cost of equity, can the WACC still fall?

8. What is the pecking order theory of capital structure? If this theory is valid, what sort of companies would you expect to see with high levels of gearing?