UNIVERSITY OF SUNDERLAND PROGRAMME

ASSESSMENT COVER SHEET / FEEDBACK FORM

Student Name & ID: SHOFAYZIEV MUSTAFO Module Name/Code: UGB363 Strategic Corporate
B1400114 Finance

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Assessment Title:

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Learning Feedback relating learning outcomes assessed and assessment criteria given to
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 ASSESSMENT COVER SHEET / FEEDBACK FORM......................................1
PART A..........................................................................................................................3
a).................................................................................................................................3
Capital structure and its meaning...........................................................................3
Theories of capital structure...................................................................................3
Approach based on net income (ni)...............................................................4
Traditional approach......................................................................................4
Approach of net operating income.................................................................4
Approach of Modigliani and Miller (MM)....................................................5
Factors that influence the capital structure.............................................................6
b)................................................................................................................................7
c).................................................................................................................................8
PART B..........................................................................................................................9
a).................................................................................................................................9
Merger....................................................................................................................9
Takeover.................................................................................................................9
Rapid economic justification................................................................................10
Scale economies of management.........................................................................10
Financial economies of scale...............................................................................10
Empirical research on acquisitions.......................................................................10
b)..............................................................................................................................11
Calculations..........................................................................................................11
Reference......................................................................................................................14
PART A

a)

Capital structure and its meaning

The combination of capitals from various sources of finance is referred to as

capital structure. The equity shareholders' fund, preference share capital, and
long-term external obligations make up a company's capital. The source and
amount of capital is determined by considering the following factors:

1.The company's capital structure should be designed so that existing owners

retain a disproportionate amount of the company's wealth.

2. In order to keep the company's financial risk under control, the capital
structure must be designed.
3. Cost: The total cost of capital stays low.

Due to the difficulty of simultaneously attaining all three of the aforementioned

objectives, a financial manager must find a middle ground between them.

A company's fundamental purpose is to maximize its value, and this is the

primary factor when deciding on the appropriate capital structure. In
determining a company's capital structure, it is important to consider the many
types of financing available (the sources to be drawn upon), the actual
amount needed (the amount to be raised), and the mix of those funding
sources.

The overall cost of capital and the firm's worth will be determined by the
weight of debt and equity in the company's capital structure. In order to
increase business value and reduce capital expenditures, a sound capital
structure is essential.

The capital structure must be taken into account when a company needs
money to invest. Financing decisions need the development of an entirely
new capital structure when it is necessary to raise money. The decision-
making process for finance or capital structure is shown in the diagram below.

Theories of capital structure

Capital structure, cost of capital, and firm value can be explained using the
following approaches:
Approach based on net income (ni)

According to this approach, the firm's value is dependent on its capital

structure. The weighted average cost of capital (WACC) will decrease as
financial leverage increases, while the firm's value and market price of
ordinary shares will rise. On the other side, a decrease in leverage leads to an
increase in the total cost of capital which in turn leads to a decrease in the
value and market price of stock.

Traditional approach

This strategy is based on the premise that the cost of capital will decrease
and the company's value will rise as a result of increased financial leverage.
Beyond this point, the patterns begin to reverse. An ideal capital structure
decreases the cost of money.
This strategy entails:

Capital structure considerations are completely immaterial according to the

net operating income methodology. Modigliani-Miller agrees with the net
operating income concept, but adds a behavioral component. Between these
two extremes, the traditional approach strikes a balance.

The Traditional Approach's Main Point

The firm's capital structure and total valuation should be optimized by careful
use of both debt and equity in the capital structure. Capital costs will be lowest
and company value highest in the optimal capital structure.

Approach of net operating income

"NOI" stands for "before interest and taxes" (EBIT). According to this
approach, the firm's capital structure decisions are insignificant.
Leverage has no effect on the value of a firm or its stock price since the
overall cost of capital is unaffected by changes in leverage. As a result, the
distinction between debt and equity has lost its significance.

An increase in the use of debt, which is ostensibly cheaper, is compensated

by an increase in the equity capitalization rate under this approach. This
occurs because, due to the presence of fixed return instruments in the capital
structure, equity investors demand better remuneration as opposed to
increased risk.

Approach of Modigliani and Miller (MM)

Non-obvious or conceptual in nature, the NOI method lacks behavioral

significance. No operational rationale is provided for the insignificance of a
company's capital structure here.

With or without taxation, the MM Approach of 1958:

If the capital market is perfect, with no transaction costs or taxes, then the
value and cost of a company's capital will not vary no matter how its capital
structure shifts. Additional assumptions include: • Capital markets are
perfectly functioning. There are no transaction fees, and all information is
publicly available.

There is no irrational investor.

Companies can be classified into 'Equivalent risk classes' based on the level
of risk they experience in their company.

• Absence of corporate income tax.

Modigliani-Miller arrived at the following three conclusions based on the

foregoing assumptions:
 1. Predicted net operating income divided by a discount rate chosen by
market participants to be appropriate for that company's risk class
equals total market value.

2. It is more expensive for a company with debt in its capital structure to

issue shares of stock. The financial risk premium will be included in the
cost of equity. The following formula is used to calculate the equity cost
of a leveraged company:

3. There is no effect on total cost of capital from the structure of the

capital (financial leverage). The level of business risk is the single
element that has an impact on the cost of capital.

Investors in the higher-valued company will unload their holdings and switch
to the lower-valued company's stock. They will be able to get the same return
for less money with the same or lower risk. As a result, they would benefit.
According to this viewpoint, the value of a levered firm cannot be larger or
lower than that of an unlevered firm. Two things have to be equal. A
company's capital structure does not benefit or harm from employing debt.
A company's capital structure is considered as a complete pie., with stock,
debt, and other securities being divided into equal parts. Regardless of how a
company's capital structure is divided (e.g., between debt, equity, etc.),
investment value is preserved. Because a company's total investment value is
based on its underlying profitability and risk, it is unaffected by changes in the
relative capitalization of the company.

This is because, in accordance with MM, a company's overall value remains

constant regardless of the funding mix.
Due to inefficiencies in the capital market, transaction costs, and the presence
of corporate income taxes, the arbitrage process proposed by Modigliani-
Miller will not work.
With Taxes: MM Approach in 1963
In 1963, the MM model was revised to include tax since it was realized that a
company's worth would rise or its cost of capital would fall if corporation taxes
were in place. Equity and debt holders in leveraged and unlevered firms will
earn substantially different amounts, and the value of the leveraged company
will be greater than the value of the unlevered company by the amount of the
total debt multiplied by the tax rate of the company.
Calculating the cost of capital (Ko) and cost of equity (Ke) for the levered firm
has been developed by MM.

Factors that influence the capital structure

Some important principles should be kept in mind when designing capital

structure, which are explained below.

Trading on equity provides financial leverage. Using long-term fixed-interest

debt and preference share capital in conjunction with equity share capital is
referred to as "leverage.". Long-term debt can enhance earnings per share if
the return on investment is greater than the cost of borrowing. Preference
share capital also boosts earnings per share, but the leverage effect of debt is
significantly greater because interest can be deducted from taxable income.
Long-term debt might have a negative impact if its interest rate is higher than
the company's expected rate of profit. This means that the company's
financing structure must be planned with care.

Two factors that affect the company's capital structure are growth and stability
in sales. It is possible for a company to raise more debt if its sales are
predicted to remain consistent. Stability in sales means that the company will
be able to meet its established commitments to repay loan interest without
problem. Capital structure decisions are also influenced by the rise in sales. In
most cases, the bigger the sales growth rate, the greater the company's
capacity for taking on debt to fund operations.

Risk Concept: According to this principle, the use of common equity rather
than excessive use of debt is preferred in financing capital requirements.
Interest payments increase as more and more debt is taken out. In a poor
business climate, this would lead to a decrease in the value of the stock held
by shareholders. Financial risk rises in direct proportion to an increase in debt.

Control Principle: Maintaining existing management control and ownership is

also a consideration for a finance manager while creating capital structures.
New equity will weaken the current control structure and will also cost more.
Increasing the amount of debt does not dilute the company's control, but it
increases the company's financial risk.

Additionally, nature of the industry, its timing, and the competitiveness in the
industry should all be taken into account. Industries that face fierce
competition are also more likely to rely on equity rather than debt to fund
operations.

Thus, a finance manager must find a balance between the above concepts
while developing a suitable capital structure. To find a middle ground,
consider how important each of these principles is to the business, and then
assign a numerical value to each of them.

b)

According to MM theory, beta changes as leverage increases. BU is the

beta of a corporation that has no debt (the unlevered beta.) Using
Hamada's equation, we can determine the beta of a leveraged firm:

BL = BU [1 + (1 - T)(D/S)]. For example, to find the cost of equity for w d =

20%, we first use Hamada’s equation to find beta:
BL = BU [1 + (1 - T)(D/S)]
= 1.0 [1 + (1-0.4) (20% / 80%)]
= 1.15
Then use CAPM to find the cost of equity:
RS = RRF + BL (RPM)
= 6% + 1.15 (6%) = 12.9%

We can repeat this for the capital structures under consideration.

WD D/S BL RS
0% 0.00 1.000 12.00
%
20% 0.25 1.150 12.90
%
30% 0.43 1.257 13.54
%
40% 0.67 1.400 14.40
%
50% 1.00 1.600 15.60
%

Next, find the WACC. For example, the WACC

for wd = 20% is: WACC = wd (1-T) rd + we
rs
WACC = 0.2 (1 – 0.4) (8%) + 0.8 (12.9%)
WACC = 11.28%

Afterwards, repeat the process for each of the potential capital arrangements.
wd rd rs WACC
0% 0.0% 12.00% 12.00%
20 8.0% 12.90% 11.28%
%
30 8.5% 13.54% 11.01%
%
40 10.0% 14.40% 11.04%
%
50 12.0% 15.60% 11.40%
%

c)
 For example, the corporate value for wd = 20% is:
V = FCF / (WACC-G)
G=0, so investment in capital is zero; so FCF = NOPAT = EBIT
(1-T). In this example, NOPAT = ($500,000)(1-0.40) =
$300,000.

Using these values, V = $300,000 / 0.1128 = $2,659,574.

For each capital structure, the following table is generated:

wd WACC Corp. Value

0% 12.00% $2,500,000
20% 11.28% $2,659,574
30% 11.01% $2,724,796
40% 11.04% $2,717,391
50% 11.40% $2,631,579
As can be shown, a 30 percent debt capital structure provides the greatest
return on investment.

PART B

a)

Merger

When two companies agree to merge, it might be viewed as a decision taken

by two "equals." Merger advantages allow the combined business to reduce
costs and enhance earnings for both groups of owners, resulting in increased
value for both groups of shareholders.

It's common for two companies to merge in order to create a new company
that is more valuable than its parts. This is called a "typical merger."

For instance, Chrysler Corp., an American manufacturer, and Daimler Benz, a

German automaker, joined in 1998 to form DaimlerChry.

The chairmen of the two previous organizations shared leadership

responsibilities in the new entity. A merger of equals was clearly in the works.
Both Chrysler and Daimler Benz hoped that the combination would help them
expand into new European markets while also giving Daimler Benz a stronger
foothold in North America.
Takeover

While a takeover, or acquisition, occurs when a larger organization acquires a

smaller one, a takeover is the opposite. The benefits of a merger can be
achieved by bringing together "unequals," but It isn't necessary that both
parties agree on this.

Smaller companies often reject hostile takeovers because they don't want to
give up control of their businesses. When a company buys another, instead of
merging with it, the acquiring company often provides the target company's
shareholders a cash price per share or the shares of the acquiring company
to the target company's owners according to a stipulated conversion ratio.
However, either method, the purchasing corporation buys the target company
for its stockholders outright, financing its purchase. The acquisition of Pixar
Animation Studios by Walt Disney in 2006 is an example of this. Due to
unanimous shareholder approval, the acquisition of Pixar was a friendly
takeover. In the event of an unwelcome hostile takeover, target corporations
might deploy a variety of techniques, including the inclusion of covenants in
their bond offerings that demand early debt payback at higher premiums if the
firm is taken over.

Rapid economic justification

Microsoft's Active Directory was being considered as an alternative to the

company's current directory systems by a leading manufacturer of electrical
equipment. A sort of study known as REJ – Rapid Economic Justification –
was used by Reply to provide a brief overview of a specific IT project's costs
and benefits to the client.

Financial advantages (business benefits) for the corporation were sought to

be highlighted by the desired assessment, which also included possible
technical motives. Calculating ROI (Return on Investment) and payback time
are critical to quickly justifying a projected investment's economic value.

Scale economies of management

Because of their size, huge organizations can afford to engage specialists.

They are better able to oversee specific parts of the business than other
employees. An experienced sales executive, for example, is capable of
handling large orders. They have high expectations in terms of compensation,
but it's well worth it.

Financial economies of scale

Because of the company's size, it is easier for the corporation to obtain

financing at a lower cost. An IPO (initial public offering) is one way for a larger
firm to raise money through the stock market. Bonds issued by large
corporations have lower interest rates because of their higher credit ratings.
 Empirical research on acquisitions

However, due to the global economic downturn and a decline in mergers and
acquisitions (M&A) activity, several empirical studies have looked at how
acquisitions affect various stakeholder groups' financial well-being. More than
130 of this research were conducted between 1971 and 2001. However,
determining whether an acquisition was a success or a failure sometimes
necessitates making a series of subjective judgments. Theoretically,
organizations engaging in acquisitions can reap the benefits of economies of
scale and synergy. Post-merger planning and management will play a major
role in determining whether or not these prospective gains can be realized in
practice. Only 20% of mergers actually succeed, say Grubb and Lamb (2000),
despite their optimism about the advantages of purchases. The majority of
mergers tend to reduce the wealth of shareholders. Studies of post-merger
integration and ways to boost acquisition performance are also well-
documented in the academic literature. Many lessons can be learned from De
Noble et al. (1988. Stakeholder groups affected by acquisitions should be
identified and the information pertaining to their impact on acquisitions should
be considered. This is the best approach to get an overall picture of whether
acquisitions are helpful.

b)

Calculations

2015 2016 2017 2018

Net sales $60.0 $90.0 $112.5 $127.5
Cost of goods sold(60%) 36.0 54.0 67.5 76.5
Selling/administrative expense 4.5 6.0 7.5 9.0

EBIT 19.5 30.0 37.5 42.0

Taxes on EBIT(40%) 7.8 12.0 15.0 16.8
NOPAT 11.7 18.0 22.5 25.2
Net Retentions 0.0 7.5 6.0 4.5
Free Cash Flow 11.7 10.5 16.5 20.7
Interest expense 5.0 6.5 6.5 7.0
Tax savings from interest $2.0 $2.6 $2.6 $2.8

r s (Target) = r RF + (r M - r RF) b Target

r sL (Target) = 7% + (4%)(1.3)
r sL (Target) = 12.2%
 r sU (Target) = (w d )( r d ) + w s(r sL)
r sU (Target) = (20%)(9%) + (80.0%)(12.2%)
r sU (Target) = 11.560%

WACC(Target) = w d (r d )(1 - T) + w s (r sL)

WACC(Target) = 1.08% + 9.76%

WACC(Target) = 10.84%

Corporate Valuation Model

FCF 2018 (1−g)

Horizon value =
WACC −g
g = 6%
20.7 (1.06)
WAAC= 10.84% =453.3
0.1084−0.06

CF0 0
CF1 11.7 F1= 1
CF2 10.5 F2 = 1
CF3 16.5 F3= 1
CF4 20.7 + 453.3 = 474.0 F4= 1

I = 10.84%
Cpt NPV = 345.26

V ops = PV at WACC = $345.3 million

- Debt $55.00
= Equity $290.3 million

Free Cash Flow to Equity Model

Free Cash Flow 11.7 10.5 16.5 20.7

Interest expense 5.0 6.5 6.5 7.0
 A-T Interest expense = Int. Exp.(1-T) $3.0 $3.9 $3.9 $4.2
Debt 55 72.2 72.2 77.8
Change in Debt 0 17.2 0 5.6
FCFE = FCF – A-T Int Exp + ∆Debt 8.7 23.8 12.6 22.1

FCFE 2018 (1−g)

Horizon value =
r sL −g

g = 6% r sL= 12.2%

22.1(1.06)
=377.84
0.122−0.06

CF0 0
CF1 8.7 F1= 1
CF2 23.8 F2 = 1
CF3 12.6 F3= 1
CF4 22.1 + 377.8 = 399.9 F4= 1

I = 12.2%
Cpt NPV = 287.9

Value of Equity = $287.9 MILLION

Adjusted Present Value Model

2015 2016 2017 2018 Horizon value (FCF) =

FCFE 2018 (1+ g)
Free Cash Flow 11.7 10.5 16.5 20.7 r sU −g

g = 6% r sL= 11.56%
Tax Shield from interest $2.0 $2.6 $2.6 $2.8

20.7(1.06) =394.6
0.1156−0.06

TS2018 (1+ g)
Horizon value (tax shield) =
r sU −g

g = 6% r sU = 11.56%
 2.8(1.06)
=53.4
0.1156−0.06

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