Traditional View of gearing and WACC

WACC= PE * Ke + PD *Kd * (1-T)

D 2000 20% 3000 27%

E 8000 80% 8000 73%
T Value of firm 10000 11000

More Gearing:
1 Proportions of D & E change WACC
2 Ke of the firm increases
Case 1 Case 2 Case 3 Case 1
PE 70% 60% 65% Decrease WACC 8.83%
Ke 11% 11.2% 20% Increase
PD 30% 40% 35% Increase
Kd 5% 5% 5%
T 25% 25% 25%
 MM View- Ignoring Taxation MM View- with Taxation

Case 2 Case 3
8.22% 14.31%
Traditional View of gearing and WACC
More Gearing
Ke increases
PE decreases
PD increases

WACC decrease BUT to a certain level of

gearing, after this very high level of
gearing, WACC will start increasing

Optimum gearing level- WACC is minimised

MM View- Ignoring Taxation MM View- with Taxation
More Gearing More Gearing
Ke increases Ke increases
PE decreases PE decreases
PD increases PD increases
WACC= PE * Ke + PD * Kd WACC= PE * Ke + PD *Kd * (1-T)

Gearing level increases- no effect on WACC Gearing level increases- WACC decreases

WACC will be same at all levels of gearing Optimum gearing level- highest practicable
level of gearing- WACC minimum that is
attainable

Firm- All Equity firm- 100% Equity

Equity 100,000 WACCg = WACCu * (1-Dt/(D+E))
Debt 20,000 More DEBT 10,000 Keg = Keu + D/E *(Keu-Kd)* (1-T)
Ke 8% Vg = Vu + Dt
Kd 4%
t 25% STEP: 1 WACCg 7.2%

WACC=? STEP: 2 WACCg = WACCu * (1-Dt/(D+E))

Ke=? WACCu = WACCg/ (1-Dt/(D+E))
V=? WACCu 7.5%

STEP: 3 WACCg = WACCu * (1-Dt/(D+E))

New Gearing level 7.05%
Equity 100,000
Debt 30,000 STEP: 1 Keg = Keu + D/E *(Keu-Kd)* (1-T)
Ke=? 8% =Keu + [(20,000/100,000) *(Keu -4%) * (100%-25
WACC=? Keu = 8% - [(20,000/100,000) *(Keu -4%) * (100%-25
Kd 4% Keu = 8% -[20% *(Keu- 4%) * 75%]
t 25% Keu = 8%- [(Keu- 4%) * 20% * 75%]
8% =Keu + [(Keu- 4%) * 20% * 75%]
8% = Keu + (Keu- 4%) * 15%
8% = Keu + 15%Keu- (4%*15%)
8% = Keu + 15%Keu- 0.6%
WACCu = Keu 8% = 100% Keu + 15% Keu - 0.6%
8% =115% Keu - 0.6%
8%+ 0.6% =115% Keu
Keu = 8.6%/ 115%
Keu 7.5%

STEP: 3 Keg = Keu + D/E *(Keu-Kd)* (1-T)

8.3%

STEP: 1 Vg 120000
Vg = Vu + Dt
STEP: 2 Vu =Vg- Dt
Vu 115000

STEP: 3 Vg = Vu + Dt
Vg 122500
 4.00%
4.00%

WACC AT OLD LEVEL OF GEARING

UNGEARED WACC 2*4*5

4*2*5

WACC AT NEW LEVEL OF GEARING

6*10^-1 6*10^-2 6*10^-3

000) *(Keu -4%) * (100%-25%)] 0.6 0.06 0.006
000) *(Keu -4%) * (100%-25%)] 15.00%

0.15

=6 * 10^-3 0.006
0.600% 0.60%

Ungeared KE

EXISTING VG

92500
 CAPM Er= Rf + B*(Rm- Rf)
Ke= Rf + B*(Rm- Rf)

1 1.5
Geared
Rf
Rm
Unlevered or ungeared beta value

Asset Beta Un geared beta

Equity Beta Geared beta
 Market Capitalization

0.75

market risk without considering the financial risk (related to debt)

market risk- business risk and financial risk
Total Price of all those shares that are going
to repurchase
Price Per share

Total number of shares

Total Capital

MV of Equity
Number of Shares=
Price per Share=

MV of Equity
Number of shares

Price per Share=

Number of Shares- $50 million of Equity

Market Capitalization= Number of shares Outstanding * Price per Share

Market Capitalization $1 billion

Number of Shares Outstanding 20 million shares

Price per Share

$100 million
$50 per year

2,000,000

Equity + Debt

= Number of Shares * Price per share

MV of Equity/ Price per Share
MV of Equity/ Number of Shares

$300 million
10 million Shares

(MV of Equity- Dividend)/ Number of Shares

1,666,667 1.67 million shares

10-1.67 8.333

$250 million
30
 1,000,000,000 $
20,000,000 Shares

50 $/ Share

million
500 million shares
$15 per share

Price per Share=

Price per Share after dividend=
Price per Share after share repurchase

$100
Tax rate= 20%

Dividend after tax= Dividend before tax- Dividend before tax* Tax rate
Dividend after tax= 100- 100*20%= 100- 20= 80

DAT= DBT - DBT* Tax rate

DAT= DBT* (1- Tax rate)
= DBT- DBT* Tax rate
 7500 million dollars
16.66667

Dividend
MV of Equity/ Total Number of Shares
(MV of Equity- Dividend)/ Total Number of shares
(MV of Equity- Amount of Repurchase)/ Total Number of Shares after Repurchase

$15 per share

14.5 500 million shares
MV of Equity=

Dividend
$0.50
1.6 $14.50
 $250 Dollars =500/250 2 shares per dollar
500 shares =250/500 0.5 dollars per share

$0.50 1 Share 500 $250.00

7500 million dollars

Dividend Re-purchase
Re-purchase 16.67 million shares
500 483.33 million shares Shares after repurchase 500
7250 7250 million dollars Equity after repurchase 7500

250.05
Price of 1 share of HNH =?

After tax return on HNH Stock= 12%

Price of one share= MV of Equity/ Number of shares
Price of one share= Earnings or Total Return on Equity/ Number of Shares

Dividend per share= Total Return on Equity/ Total number of shares

Before Tax Dividend per share= Before Tax Return on Equity/ Total Number of shares
After Tax Dividend per share= After Tax Return on Equity/ Total Number of Shares

=>$ 1.6 = Dividend= Return ($)

Return on 1 share= 12% of the Price of 1 share

$1.6= 12% * Price of 1 share

Price of 1 share= $1.6/ 12%
13.33 $
Investment
1000 10%
90.91

Investment 1000
Capital invested by shareholders 800
Capital invested by lenders 200
Capital in a firm 1000

EBIT CASH FLOW 600

1800
At the end of year
100

Total Return
Return 100 10%
Net income 200 25%
Interest expense 20 10%
Net income + Interest expense

=500+100

1 2 3 4
Sales 800 1100
COS
Net Income (cash+non-cash) (Cash and Non- Cash)
Add back: Depreciation + Depreciation
cash outflow -cash capital expenditure
=Cash flow available to shareholders
+ After tax interest expense =50* (1-T)
=Cash flow available to all investors

FCFF
 total Sales receivable
Sales in year 1 1000 200 800
Sales in year 2 1200 300 900

year 1 year 2
900 100
Sales 1000
Cos 200
Gross Profit 800
Admin & Selling 200
Depreciation 100
EBIT 500
Add back: Depreciation 100
EBIT/ Cash flows from Operations 600
5 Interest expense 50
Earnings before Tax 550
Tax expense 100
Operating cash flow after taxes- shareholders 450

Operating cash flow available to investors 500

fcff= OCF- Initial investment

FCFF = NI + D&A +INT(1 – TAX RATE) – CAPEX – Δ Net WC
FCFF = CASH FLOW RETURN ON CAPITAL
WACC RATE
PRESENT VALUE OF FCFF
 Today
equity+debt Today
6500 Year 0 Year 1 year 2
Net income 3000 5000
+dep/amo
+After tax interes
- CAPEX
- NET WC
=FCFF 1000 1200
WACC 7% 10351.89 934.58 2242.99

Total investment 6500 today's value

Total return on investment 10351.89 today's value
3851.89 Gain to investors
year 3 4 5 6 & onwards
4000 4500 5200

1500 3500 4600

1224.45 2670.13 3279.74
 Acquirer Acquired
Siena Maive
P/E 6 4
Shares Outstanding 500000 220000
Earnings 2000000 660000

Current Dividend per Share $1

Dividend growth rate

estimated by securities
analysts 4%

Dividend growth rate

estimated by Siena's
Management 6%

a) Post- Acquisition Value of

Maive=?

Post acquisition Value of

Firm= =Price of share* Number of Shares
$ 3,495,800 After acquisition value
(Price per share)/ (Earnings per Share) =P/E
Total Price/Total Earnings =P/E
Total Price= 2640000 Before acquisition Maive
Total Price= P/E * Total Earnings 12000000 Before acquisition Siena

Price per Share= 12 Dollar per Share

Current Required rate of return = [[D *(1+g)]/P] + g

12.67%
P= 15

Total Value of Siena after acquiring Maive $ 15,495,800

 Rate of Return=

15.8920539730135

Purchase (b) $15 15

Purchase © Share exchange $ 27.9 15

PART C

At Share Exchange Ratio of 1:4

After Acquisition

Price per share of Siena after acquiring Maive

Price per share of Siena after acquiring Maive

P/E ratio=?
Total Price or Value of the merged firm=

(Price per share)/ (Earnings per Share)

Total Price/Total Earnings
 PART D
Let Share Exchange Ratio be 'X'

X= Share Exchange Ratio Shares in the merged firm=

Total Price or Value of the merged firm=

Price per Share of merged firm=

15/X
15/X* (500000+220000X)
15*(500000+220000X)
500000+220000X
500000+220000X
1033053.33X - 220000X
813053.33X
X
X
 12300
6150

10492

[D* (1+g)/ P] + g

$15.89 per Share 1.06

k= 10.93%

RT C
Siena Maive

500000 220000

555000 Number of Shares

= Total Price or Value OF Siena after acquiring Maive/

Number OF Shares OF Siena after acquiring Maive
15495800 $

27.9 $

$ 15,495,800

=P/E
=P/E
500000+ (220000* X)
$ 15,495,800

Total Price of merged firm/ Shares in merged firm

=15,495,800/ (500000+ 220000X)
15,495,800
=15495800*X
=(15495800*X)/15 1033053.33333333
=1033053.33*X
=500000 813053.333333333
=500000
=500000/813053.33
0.61
 6350

4500 5992 6192

6192

=1.06/(0.

21.5010141988
Price per share $21.50
$4,730,000.00

Siena Maive

1 4
55000 220000 1/4 = Siena's Shares/ Maives's Shares
Shares Exchange Ratio
 12

million Depreciation
1.2
418414 1000 100 900 90
1200000

781585.9 729
810 81 729
P/E
Shares Outstanding
Earnings
Total Price before acquisition
Price per share before acquisition

IF TAKEOVER IS FUNDED BY CASH:

Cost of Acquisition to Nadia in Alternative 1:
Nadia will pay $15 per share of Shaan
For acquiring 220,000 shares of Shaan:
Amount paid by Nadia=
Nadia will get shares of shaan in return- Current value of Shaan=
Cost of acquisition to Nadia= 3300000- 26400000

IF TAKEOVER IS FUNDED BY STOCKS:

Now, Cost of acquisition to Nadia in Alternative 2:
Shares allotted to Shaan based on Share Exchange ratio= 220,000* 1/4
Total Market value of merged entity=
Total Market value of merged entity=
Total Market value of merged entity=
Now, Total number of shares of merged firm=
Price per Share of merged firm=

Value of Shaan's Shares in the merged firm based on merged share price=
Value of Shaan's Shares in the merged firm based on merged share price=
AND
Value of Shaan's Shares based on Nadia's post acquisition share price=
Value of Shaan's Shares based on Nadia's post acquisition share price=

Difference= Cost of acquisition to Nadia= 1657700-1320000

W-1 Calculation of Post acquisition value of Shaan:

Required rate of return using 4% dividend growth rate= (P=$12, D=$1, g= 0.04)
Price per Share of Shaan after acquisition= (g= 0.06, k=0.1093)

Total value of Shaan after acquisition= 21.5 price per share * 220000 shares

RESULT:
NADIA WILL CHOOSE SHARE EXCHANGE OPTION BECAUSE ITS COST OF ACQUISITION IS LOWER THAN THE OTHER OPTION
 Nadia Shaan
8 6
500000 220000
$1,500,000 $440,000
$12,000,000 $2,640,000
$24 $12

$15*220000= $ 3,300,000 Amount paid by Nadia

$12*220000= $ 2,640,000 Value received by Nadia in return of payment
$ 660,000 Cost of acquisition in Alternative 1

55000 shares
Value of Nadia+ Post acquisition value of Shaan
=12,000,000+4,730,000 Note: From W-1 Below
$ 16,730,000
555000
$ 30.14

=30.14*55000
$ 1,657,700

=24*55000
$ 1,320,000

$ 337,700

12.67%
21.5 per share

$ 4,730,000

WER THAN THE OTHER OPTION