COVENANT FINANCIAL CONSULTANTS FINANCIAL GEARING AND CAPITAL STUCTURE

CAPITAL STRUCTURE AND GEARING-REVIEW QUESTIONS

QUESTION ONE
i. How does sales stability affect the target capital structure?

ii. How do the types of assets used affect a firm’s capital structure?

iii. How do taxes affect the target capital structure?

iv. How do lender and rating agency attitudes affect capital structure?

v. How does the firm’s internal condition affect its actual capital structure?

vi. What is “financial flexibility,” and is it increased or decreased by a high debt ratio?

Please visit our website at www.covenantfinco.com

 COVENANT FINANCIAL CONSULTANTS FINANCIAL GEARING AND CAPITAL STUCTURE

QUESTION THREE (Traditional Theory - Advanced)

Analysis by a consultant hired by ImaChris Ltd indicates that both the after-tax cost of debt and
cost of equity change with the level of leverage. The consultant suggests that the most likely cost
of each component for the different capital structure is as follows:

Debt/Assets After-tax cost of Cost of Wd We WACC

Debt(Kd AT) equity(Ke)
0% 8% 12% 0 1 0.12
10% 8% 12% 0.1 0.9 0.116
20% 8% 12% 0.2 0.8 0.112
30% 9% 12% 0.3 0.7 0.111
40% 9% 13% 0.4 0.6 0.114
50% 10% 15% 0.5 0.5 0.125
60% 12% 17% 0.6 0.4 0.14

The consultant heard that you are pursuing an intermediate stage of becoming a CPA (T) and has
requested you to:
i) Explain the possible reason for the increase in both the after-tax cost of debt and cost of equity
as ImaChris becomes more financially leverage (assuming the tax rate is constant)
Answer: This is due to increase in financial risk. Financial risk is caused by increasing debt than
equity. Due to risk & Return relationship as risk increases, returns also increase. This is to say
both equity holders and debt holders will require higher returns given the higher financial risk
causing an increase in Kd and Ke respectively.
i) Find the optimal capital structure (that is, optimal combination of debt and equity
financing) for ImaChris Ltd.
Answer: Optimal capital structure is when the WACC is minimized. From the computation above
the optimal capital structure is 30% debt and 70% Equity where WACC is 0.111.
ii) Why does the overall cost of capital for ImaChris Ltd initially decline as the firm substitutes
debt for equity financing?
Answer: At low level of debt normally debt is cheaper than equity resulting to low Kd. It should
be remembered that Kd is one of the inputs in computing WACC hence at low level of debt
increasing debt will initially cause WACC to decrease.
iii) Why does the overall cost of capital for ImaChris Ltd eventually rise as the firm becomes
more financially leveraged?
Answer: This is due to an increase in financial risk hence Investors(D&E) requires high returns.
iv) If ImaChris Ltd were using 60% debt and 40% equity, what would that tell about the firm’s
use of financial leverage?
Answer: If 60% Debt and 40% equity, the coy will be over utilizing debt and hence not be at an
optimal capital structure. To go back to an optimal capital structure the coy should reduce its
current level of debt
v) If the ImaChris Ltd were using 30% debt and 70% equity and earned 11.8% on an
investment, would this mean that stockholders receive less than the required rate of return
of 12%? What would the stockholders’ rate of return be?
Answer: Wd = 30%, We=70%, WACC=11.8%, kd=9% => WACC = kdWd +KeWe

Please visit our website at www.covenantfinco.com

 COVENANT FINANCIAL CONSULTANTS FINANCIAL GEARING AND CAPITAL STUCTURE

0.118 = 0.09 × 0.3 + 𝐾𝑒 × 0.7 => Ke = 13%; Therefore this would not mean that stock
holders receive less than 12% instead they receive 13%
New Cost of Equity = 13.16%

QUESTION SIX (MM Theory)

Solution:
(a)
(i) Given that the value of the unlevered firm is 640,000 and because tax bracket (rate) is 0
then value of levered firm = value of Unlevered firm VUF = VLF
Value of firm after change = 640,000
VF = VE + VD
VF = [640,000 – 300,000] + 300,000 = 640,000

(ii) Share price:

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑖𝑟𝑚 𝑇𝑍𝑆 640,000
Share price before change = = = 𝑇𝑍𝑆20/𝑠ℎ𝑎𝑟𝑒
𝑛𝑜.𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 32,000 𝑠ℎ𝑎𝑟𝑒𝑠

How many shares would be outstanding after change?

Remember: The amount borrowed will be used to repurchase shares

300,000
Number of shares repurchased = = 15,000 shares
20
Therefore outstanding shares = 32,000 – 15,000 = 17,000 shares

Alternatively: New Equity Value = 640,000 – 300,000 = 340,000

Outstanding shares = 340,000/ 20 = 17,000 shares
Revised Share price = Revised Value of Equity/Revised No. of shares
outstanding=340,000/17,000 = TZS 20/share

(b) VF = VUF + tax benefit

VUF = 𝑁𝑜. 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 × 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 = 5000 × 7 = 𝑇𝑍𝑆 35,000
Tax benefit = 𝐷𝑒𝑏𝑡 × 𝑇𝑎𝑥 𝑟𝑎𝑡𝑒 = 10,000 × 25% = 2,500
VF = 35,000 + 2,500 = 37,500
VF = VE + VD
37,500 = VE + 10,000 => VE = 37,500 – 10,000 => VE = TZS 27,500

Please visit our website at www.covenantfinco.com

 COVENANT FINANCIAL CONSULTANTS FINANCIAL GEARING AND CAPITAL STUCTURE

QUESTION EIGHT: (Levered and Unlevered Beta + Traditional Theory)

Solution:

(a) (b) (c) (d) (e)

Wd KdAT We BL = BU(1 + (1 –T) D/E) Ke = Rf + B(Risk Premium) WACC = (a) x (b) + (c) x (d)

0 10% 100% 1.5 0.09 + 1.5(0.083) = 0.2145 (0 x 0.1 )+ (1 x 0.2145) =0.2145

10% 10.5% 90% 1.5(1 + (1-0.4)x1/9)=1.6 0.09 + 1.6(0.083) = 0.2228 (0.1 x 0.105)+ (0.9 x 0.2228) = 0.2115
20% 11% 80% 1.5(1 + (1-0.4)x2/8)=1.73 0.09 + 1.73(0.083)=0.2332 (0.2x0.11)+(0.8x0.2332)=0.20856
30% 12% 70% 1.5(1 + (1-0.4)x3/7 )=1.89 0.09 + 1.89(0.083)=0.2465 (0.3x0.12)+(0.7x0.2465)=0.20855
40% 13% 60% 1.5(1 + (1-0.4)x4/6) =2.10 0.09 + 2.10(0.083)=0.2643 (0.4x0.13)+(0.6x0.2643)=0.2106
50% 14% 50% 1.5(1 + (1-0.4)x5/5)=2.40 0.09 + 2.40(0.083)=0.2892 (0.5x0.14)+(0.5x0.2892)=0.2146
60% 16% 40% 1.5(1 + (1-0.4)x6/4)=2.85 0.09 + 2.85(0.083)=0.3266 (0.6x0.16)+(0.4x0.3266)=0.2266
70% 18% 30% 1.5(1 + (1-0.4)x7/3)=3.60 0.09 + 3.60(0.083)=0.3888 (0.7x0.18)+(0.3x0.3888)=0.2426
80% 20% 20% 1.5(1 + (1-0.4)x8/2)=5.10 0.09 + 5.1(00.083)=0.5133 (0.8x0.20)+(0.2x0.5133)=0.2627
90% 25% 10% 1.5(1 + (1-0.4)x9/1)=9.60 0.09 + 9.60(0.083)=0.8868 (0.9x0.25)+(0.1x0.8868)=0.3137

Conclusion: The optimal debt ratio is 30% where WACC is minimized (i.e. minimum WACC is 0.20855)

Please visit our website at www.covenantfinco.com