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M12 - Set 4
M12 - Set 4
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Exam Focused Notes
Mark Baines
mark.baines@kaplan.com
© Kaplan Financial (HK) Limited 2021
The copyright of these materials belongs to Kaplan Financial (HK) Limited. It is intended to be used for
students who attend Kaplan Financial (HK) Limited’s courses. These materials cannot be resold or reused
for any other purposes.
FINANCIAL MANAGEMENT PART III
CONTENTS PAGE
1 -n
Present value factor: or (1 + r)
(1 + r ) n
Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 2
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 3
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 4
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 5
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 6
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 7
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 8
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 9
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 10
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 11
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 12
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 13
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 14
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 15
11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 2
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 3
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 4
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 5
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 6
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 7
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 8
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 9
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 10
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 11
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 12
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 13
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 14
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065 15
ANNUITY TABLES
1− (1+ r )−n
Annuity factor:
r
Where: r = discount rate
n = number of periods
Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 2
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 3
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 4
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 5
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 6
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 7
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 8
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 9
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 10
11 10.370 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 11
12 11.260 10.580 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 12
13 12.130 11.350 10.630 9.986 9.394 8.853 8.358 7.904 7.487 7.103 13
14 13.000 12.110 11.300 10.560 9.899 9.295 8.745 8.244 7.786 7.367 14
15 13.870 12.850 11.940 11.120 10.380 9.712 9.108 8.559 8.061 7.606 15
11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 2
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 3
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 4
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 5
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 6
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 7
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 8
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 9
10 5.889 5.560 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 10
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.586 4.327 11
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439 12
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 13
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 14
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 15
The weighted average cost of capital (WACC) is calculated by taking into consideration the required
return of its debt and equity investors weighted to their respective market values.
WACC = Ke x E + Kd x D
E+D AT E + D
Market value of equity = No. of ordinary shares (common stock) x current market share price
Market value of debt = No. of tradable securities x current market tradable price
WACC
D Do x (1 + g)
Ke = Ke = +g i (1 - t) (IRR)
Po Po Kdat = Financial
Po
Calculator
Estimating g
Other types bonds
Compound method
Arithmetic average Convertible
Gordon growth bonds
D
Po =
Ke
Ke - Cost of equity
D
Ke =
Po
Key: D = Constant dividend from year 1 to infinity
Po = Ex div share price now (year 0)
Ke = Shareholders’ required return, expressed as a decimal.
CONSTANT GROWTH
Do(1 + g )
Po - “Ex div.” share price Po =
ke - g
Do(1 + g )
Ke - Cost of equity Ke = +g
Po
Key: g = constant rate of growth in dividends, expressed as a decimal.
D1 = Do * (1 + g) dividend at the end of year 1.
1
g= n last dividend - 1 last dividend n
or - 1
first dividend first dividend
1
g= 4 14.5 - 1 14.5 4
or - 1
10 10
= 0.0973 or 9.73%
*Student note: There is five years of dividend data, but FOUR years of dividend growth!
A company has a dividend history of $0.65, $0.70, $0.72, and $0.75 per share over the last four years,
respectively.
Calculate a simple arithmetic average of dividend growth rate for the past four years.
Alternatively, the growth rate can be estimated using Gordon's growth approximation. The rate of
growth in dividends is sometimes expressed, theoretically as g = b x r
If a company retains 71% of its earnings for capital investment projects it has identified and these
projects are expected to have an average return of 5%
g = b x r = 71% × 5% = 3.55%
DVM Advantages:
• Quick and simple to calculate.
• Based on shareholders dividend cash returns.
DVM Disadvantages / Limitations:
• Po can be subject to short-term influences which distort the estimate of the cost of equity.
• In reality dividends grow, but not at a constant rate.
• Difficulty in estimating future dividend growth rates.
• It does not take share price capital gains into account.
• A simple perpetuity formulae which ignores risk.
Unsystematic
risk
Unsystematic / Specific risk – refers to the impact on a company’s cash flows of largely random
positive and negative events such as the weather, R&D Innovation breakthroughs, winning a
large contract, or industrial relations problems (strike action), equipment failure, etc.
In a portfolio such random factors tend to cancel as the number of investments in the
portfolio increase.
Systematic / Market risk – these are general economic factors that affect the cash flows of all
companies in a same consistent manner like the rate of economic growth, tax rates, etc.
Since these factors cause returns to move in the same direction they cannot be cancelled
out. Therefore systematic (market) risk remains present in all portfolios.
2. Financial risk comes from the company's financial gearing (amount of debt versus equity).
Because debt is a fixed cost it causes high variations in equity earnings (shareholders returns)
compared with variations in operating profit.
Alfred Sim has recently joined Callimed as the Finance Director. Callimed is a privately-held company
selling specialised medical equipment to clinics and hospitals in Hong Kong. When attending his first
Investment Committee Meeting in Callimed, Alfred noticed that the company does not conduct formal
quantitative analysis on investment proposals, and nobody in the committee seems to have any idea
about the company’s WACC.
As the Finance Manager of Callimed, you have been requested by the Finance Director to work out
the WACC. You have gathered the following financial information about the company:
In Callimed’s balance sheet, total asset ($462M) comprises $387M of fixed assets and $75M of
current assets. For the liabilities totaling $165M, the proportion of long-term liabilities (interest bearing)
and current liabilities (non-interest bearing) are 80:20. Equity amounts to $297M.
Companies of a similar business nature and financial position as Callimed have to pay 8.5% to raise
long-term financing and are of a beta of 1.18.
Required:
(a) Based on the above information, calculate the WACC of Callimed. (10 marks)
(b) Alfred has asked you to attend the next Investment Committee meeting to explain to the
committee members about best practices in the estimation of WACC. What would be the
points that you will highlight? (8 marks)
Recommended solution
(a)
Cost of equity
Ke = Rf + (βe x risk premium)
= 5.5% + 1.18 x 8% 14.94%
Cost of debt
KdAT = Kd x (1 - t)
= 8.5% x (1 – 0.16) 7.14%
WACC
Long-term debt ($165M x 0.8) = $132M
WACC = 12.54%
(b)
The weighted average cost of capital (WACC) represents the return required for Callimed’s Equity
shareholders and Debt lenders, useful for quantitative analysis by discounting investment proposal
cash flows.
The weightings in the WACC should be based on market values of debt and equity and not
Callimed’s book values as these are likely to give misleading results.
A business valuation exercise should be done using a similar listed business, as this would reveal
equivalent market values to be used for Callimed’s relative market values of equity and debt.
The after-tax costs of debts should be estimated from Callimed’s corporate pre-tax debt costs by
adjusting only the interest payments i(1 - t) within the cost of debt formulae.
Betas for listed companies should be drawn from published sources such as Bloomberg, and risk
adjusted for differences between the listed company and Callimed’s business.
CAPM is currently the preferred model for estimating the cost of equity as it incorporates risk into
Callimed’s cost of equity, whereas DVM ignores risk as it’s based on a simple perpetuity formulae.
The risk-free rate should match the length of the cash flows of the project, so if Callimed is
evaluating a 5 year investment project it should use a 5 year government bond yield.
Although choice of an equity market risk premium is the subject of considerable controversy, most
best-practice companies use a premium of 6% found in Barclays equity study.
Callimed’s WACC should be updated regularly at least once a year or if there has been major
changes in the financial markets affecting markets value weightings and costs of its capital.
EFG Limited, a Hong Kong listed company, has 200,000 bonds outstanding that are selling at 97.5%
of face value of $1,000 each. Bonds with similar characteristics are yielding 6.75% pretax.
The company also has 2,250,000 shares of 7% preferred stock (par value = $100) and 7,500,000
shares of common stock outstanding. The preferred stock sells for $50 a share.
The common stock has a beta of 1.34 and sells for $62 a share. The risk free rate is 2.8% and the
return on the market is 11.2%. The corporate tax rate is 16.5%.
Required:
Recommended Solution
WACC
WACC = (14.06% x 60.19%) + (5.64% x 25.24%) + (14% x 14.56%)
WACC = 11.92%
Wellgas Oil & Gas Limited (“Wellgas”) refines automobile petrol and distributes it through its own
Wellgas petrol stations in Hong Kong. It has been a publicly listed firm on the Growth Enterprise
Market of the HK Stock Exchange since 2013.
Wellgas has 80 million shares of common stock outstanding at a price of HKD64 per share and the
required rate of return is 15%. Also, it has 20 million shares of preferred shares outstanding at a price
of HKD54 per share and paying a HKD6 dividend.
The outstanding debt has a total face value of HKD1 billion and a market price equal to 102% of the
face value. The yield to maturity on the debt is 6.33%. The marginal tax rate of Wellgas is 15%.
Required:
Recommended Solution
WACC
WACC = (15% x 70.91%) + (5.38% x 14.13%) + (11.11% x 14.96%)
WACC = 13.06%
EXAM TRICKS
• The terms debentures, bonds, loan stock and tradable debt all mean the same thing.
• Debt is often quoted in $1,000 nominal units, par, face value or blocks.
• Debt can be quoted as a percentage or as a value (i.e. trading at 97 means 97% or $970)
the examiner is telling you $1,000 nominal value of debt is worth $970 market value.
• Redeemable debt can be redeemed above or below its $1,000 nominal value. A $1,000
nominal value bond redeemable at 110 would mean the bond is redeemed at 110% greater
than its nominal value or $1,100.
• The redemption value is agreed at the time of issue, but if the question is silent on this
matter, we can assume it is redeemed at par i.e. $1,000 repayment per $1,000 nominal
value.
• Interest paid on debt is stated as a percentage of nominal value. That is the coupon rate,
e.g. an 8% coupon rate means that $80 of interest will be paid on $1,000 nominal value block
of debt.
• The coupon rate is fixed at the time of issue, in line with the prevailing market interest rate
(HIBOR).
• The market value of debentures may change daily. The main influence on the price of a
debenture is the general level of interest rates (HIBOR), the level of risk and the period to
maturity (redemption).
• From the companies perspective the cost of debt should always be adjusted for taxation.
The market price of an irredeemable bond (Po) is a simple perpetuity formula, as interest is paid
in perpetuity forever:
i
Po =
Kd
The cost of irredeemable debt capital, with a current ex-interest price Po is given by the formula:
i
Kd =
Po
Kaplan Example - Cost of Irredeemable Debt before tax = Yield = Return to the bondholder
Gund Corp has issued bonds of $1,000 nominal value with a coupon rate of 9%. The current market
price of the bonds is $900.
i $90
Kd = = = 10.00%
Po $900
The above equation cannot be simplified, so “kd” will have to be calculated either by using a
financial calculator or using linear interpolation as an internal rate of return (IRR).
Disc. Disc.
Year Cash flow Factors Factors
@ 5% PV @ 15% PV
0 Market value (900.00) 1 (900.00) 1 (900.00)
Annuity → 1 – 10 Interest i x (1 - t) 83.50 7.722 644.79 5.019 419.09
10 Capital repayment 1000.00 .614 614.00 .247 247.00
358.79
KdAT (IRR) = ≈ 5 + × (15 − 5) = 11.05%
358.79 + 233.91
Using a linear interpolation method only roughly estimates the IRR (cost of debt). For accuracy a
financial calculator is required.
Use the Texas Instruments BA II Plus calculator to calculate the accurate IRR unless otherwise told in
the exam:
If a company pays $0.1 million a year interest on irredeemable bonds with a nominal value of $1
million and a market price of $0.8 million, and the rate of tax is 16.5%, the cost of the debt would be:
i x (1 - t) $0.1m x (1 - 0.165)
KdAT = = = 10.44%
Po $0.8m
The higher the rate of tax is, the greater the tax benefits in having debt finance will be compared
with equity finance.
In the example above, if the rate of tax had been, say 50%, the cost of debt would have been, after
tax:
i x (1 - t) $0.1m x (1 - 0.50)
KdAT = = = 6.25%
Po $0.8m
You ONLY adjust for tax when calculating the ‘Cost of Debt’ from the companies point of view
for the WACC!
NEVER ADJUST when calculating the ‘Bond Market Price’ from anyone’s point of view or
‘Bond Yield’ or ‘Bondholders return’ from the bond holders point of view!
The cost of capital of convertible debt is harder to determine as the calculation depends on whether
or not conversion is likely to happen.
• If conversion is not expected, the conversion value is ignored and the bond is treated as
redeemable debt, using the financial calculator (IRR) method described earlier.
• If conversion is expected, the financial calculator (IRR) method for calculating the cost of
redeemable debt is used, but the redemption value is replaced by the conversion value i.e. the
market value of the shares into which the debt can be converted.
A company has 9% convertible loan stock which is currently trading at $870. Conversion into ordinary
shares can take place in seven years time at a rate of 400 shares per $1000 debt. The debt holder
could alternatively redeem the debt at par value. The current share price is $2.00 per share.
Required:
Determine whether conversion into shares is likely to take place if the estimated growth rates
are 3% and 4%, and the Yield to maturity (cost of debt) for each of the growth estimates.
(10 marks)
Recommended solution
0 1 2 3 4 5 6 7
$2.00 x 1.037 = $2.46
Conversion is unlikely as the conversion value of $984 is less than the redemption value of $1,000.
Cost of debt
To calculate the cost of debt (IRR) either a linear interpolation or financial calculator approach can be
taken – in the exam use a financial calculator unless told otherwise!!!
0 1 2 3 4 5 6 7
Conversion is likely as the conversion value of $1,052 is higher than the redemption value of $1,000.
Cost of debt
To calculate the cost of debt (IRR) either a linear interpolation or financial calculator approach can be
taken – in the exam use a financial calculator unless told otherwise!!!
D
Kpref =
Po
Key: D = Annual Preference dividend (Par $ value x Preference % rate)
Po = Preference share price now (year 0)
Tax relief is not given for preference share dividends, as dividends are not tax deductible.
When calculating the weighted average cost of capital the cost of preference shares is a separate
component and should not be combined with the cost of debt or the cost of equity.
Simply extend the WACC to include three weighted average sources of capital like the next question.
XYZ, established 10 years ago, is a listed medium size real estate development company in Hong
Kong. Its capital structure is made up of the following components:
The preference shares are selling for $60 a share. The common stock has a beta of 1.5 and sells for
$50 a share.
Required:
(b) XYZ is considering diversifying into the media business in mainland China and is
considering a major investment proposal. The Board requires NPV as the quantitative
evaluation tool and one of the Board members indicates that the firm’s WACC can be
used to discount the project cash flow to arrive at the NPV. Write a memo to the Board,
in your capacity as the Finance Director of XYZ, to explain the appropriateness of this
suggestion. State reasons to justify your answers.
(5 marks)
Recommended solution
(a)
Assuming the market interest rate (HIBOR) has not changed and the bonds are trading at their issue
price (par value) of $1,000.
Market Values Weighting %
Common Stock: 5,000,000 x $50 = $250,000,000 65.79%
Bonds: 10,000 x $1,000 = $10,000,000 2.63%
Preference Stock: 2,000,000 x $60 = $120,000,000 31.58%
Total market value $380,000,000 100.000%
WACC
WACC = (21% x 65.79%) + (5.85% x 2.63%) + (11.67% x 31.58%)
WACC = 17.65%
(b) MEMO
Date : xx/xx/xxxx
To : Board of Directors
From : Finance Director
The firm’s WACC should not be used as the discount rate, because WACC reflects the risk of the
company’s business and in this case, real estate development.
WACC can be used to evaluate the investment proposal as long as the project risk is the same
as the business risk of the company – for instance expanding the current real estate business.
Since the project is in media, a totally different business from real estate, the risk would not
represented by using the existing WACC.
Another reason the existing WACC cannot be used is that XYZ is a HK company and the media
business is based in mainland China.
As the economic, regulation and legal environment of HK is different from that of mainland
China, this is another risk difference, which is not represented by the existing WACC.
The same as with the cost of convertible debt earlier, the valuation depends on whether the bond
is likely to be converted.
If conversion is unlikely the redemption value [FV] would be $1000. If conversion is likely, the
redemption value is replaced by the conversion value i.e. the market value of the shares into which
the debt can be converted, as shown in the cost of convertible debt example earlier.
CONVERSION PREMIUM
Dec17 B1; Dec20 A2
A conversion premium is the amount by which the price of the convertible bond exceeds the
current conversion value (the total current market value of the shares) into which the debt can
be converted.
Conversion Premium = Convertible Bond Price – Current Conversion Value
The conversion premium is usually positive because of the expectation of future share price
growth increasing the conversion value when the bond is converted in the future.
WON can issue a HK$100 million value of convertible bonds at the beginning of year 1 with maturity
at the end of year 3, convertible at the option of bondholders. Based on the calculation by the
investment advisor, the company could issue a convertible bond that has HK$1,000 par value. The
coupon rate is 6% p.a. and coupon payments are made semi-annually. The required rate of return on
the bond is the same as the coupon rate.
The current conversion value and share price are HK$1,400 and HK$70 per share respectively. If no
conversion is made, the bond will be redeemed at HK$1,100. The Board of Directors is not familiar
with convertible bonds, but Peter likes the idea and would like to do it as soon as possible so that he
can start the IoT gift product project.
Required:
Calculate the convertible bond price assuming no conversion, the number of ordinary shares
conversion per bond, the par value of convertible bond per ordinary share, the conversion
premium of a convertible bond and explain the meaning of conversion premium based on the
calculation result.
(6 marks)
Recommended solution
CONVERTIBLE BOND PRICE
USING A FINANCIAL CALCULATOR (RECOMMENDED APPROACH)
PROCEDURE KEYSTROKE DISPLAY
Set all variables to defaults [2ND] [RESET] [ENTER] RST 0.00
Set payments per year to 1 [2ND] [P/Y] 2 [ENTER] P/Y = 2.00
Return to calculator mode [2ND] [QUIT] 0.00
Enter number of remaining 6 [N] N= 6.00
coupon payments
Enter coupon payment 30 [PMT] PMT = 30.00
Enter redemption value* 1,100 [FV] FV = 1,100.00
Enter yield to maturity (Kd) 6 [I/Y] I/Y = 6.00
Compute Convertible Bond price [CPT] [PV] PV = -1,083.75
Convertible Bond Price = HK$1,083.75
*Student note: Since the requirement states ‘assuming no conversion’ we can go straight into the
financial calculator workings without estimating value of the share in 3 years and likely conversion!
Also do not confuse redemption value with par value, as explained earlier they can be different. Only
assume the bond is redeemable at par unless you are told otherwise!
CONVERSION PREMIUM
Conversion premium = Convertible Bond Price – Current Conversion Value
= HK$1,083.75 – HK$1,400 (or HK$70 x 20 shares)
= - HK$316.25
A conversion premium is the amount by which the price of a convertible bond exceeds the current
market value of the shares and is usually positive because of the expectation of future share
price growth increasing the conversion value when the bond is converted.
However, in WONs case the conversion premium is negative at -HK$316.25 reflecting the fact we
have assumed ‘no conversion’ in the above convertible bond price calculations reducing its value.
A negative conversion premium would indicate that conversion is unattractive as future share price
is expected to decrease from its current HK$70 value, making future conversion unlikely.
Required:
(b) If management is very confident that the compound growth rate of the share price will
be 5% per year for the next four years, calculate the price of Bond B and the
conversion premium. Assume no transaction cost.
(8 marks)
(c) A bond investor who needs a higher stable annual income does not plan to hold any
bond until maturity. Advise the bond investor with explanations, as to whether he /
she should invest in Bond A or Bond C.
(6 marks)
Recommended solution
(a) BOND A PRICE:
USING A FINANCIAL CALCULATOR (RECOMMENDED APPROACH)
PROCEDURE KEYSTROKE DISPLAY
Set all variables to defaults [2ND] [RESET] [ENTER] RST 0.00
Set payments per year to 1 [2ND] [P/Y] 1 [ENTER] P/Y = 1.00
Return to calculator mode [2ND] [QUIT] 0.00
0 1 2 3 4
$45.00 x 1.054 = $54.70
Conversion value = $54.70 x 20 shares = $1,094 Convert
Redemption value (assuming redemption is at par) = $1,000 Redeem
Conversion is likely as the $1,094 conversion value is higher than the redemption value of $1,000
Conversion premium = Convertible Bond price – Current market price of 20 ordinary shares
= HK$1,173.33 - HK$45 x 20
= HK$273.33
Required:
(a) What are the major characteristics of commercial papers? (4 marks)
(b) Why is the stand-by letter of credit important to holders of commercial papers? (3 marks)
(c) What is the major financial risk faced by NB Steel if the commercial papers cannot be rolled
over? In your opinion, how can this risk be mitigated through an appropriate financing
strategy? (6 marks)
(d) Based on Justin’s estimation, calculate the respective market values of the two bonds in
NB Steel’s fixed-income portfolio. (5 marks)
(e) Compute the yield of the fixed-income portfolio. (Hint: work out the interest rate that will
make the present value of the total cash flows of the two bonds equal to the market value
of the portfolio). (4 marks)
(f) If a fixed-income fund manager offers a yield to maturity of 9% to purchase the entire
portfolio from NB Steel, is the price offered by the fund manager better than the values
calculated in (d). (4 marks)
Recommended solution
(a)
A commercial paper is an unsecured note issued on a discount basis ranging from 1 to 270 days,
although longer maturity is possible if it is placed privately.
Principal buyers include institutional investors, insurance companies, pension funds and banks.
Credit ratings on commercial papers are normally required by investors, and a stand-by letter of
credit is usually in place as a form of credit enhancement.
(b)
Stand-by letter of credit is a way to enhance the credit of the commercial paper as it is a back-up
form of credit for the issuer.
The stand-by letter of credit facility provides insurance for the holders of the commercial papers
in case the issuers cannot repay or refinance the debt.
In such a case, the holders can rely on the credit facility for repayment of the debt.
(c)
Financial risk
The major financial risk to NB Steel is the liquidity risk from a mismatch between its long-term
investment in assets and the companies use of short-term funding.
A very large 80% of NB Steel’s debt requirements of USD5 billion is made using short-term
commercial papers.
As commercial papers have relatively short maturity, failing to roll over these short-term debts
will immediately cause liquidity cash flow problems for the company.
The steel industry is capital intensive and requires significant investment in plant and machinery,
making longer term financing more suitable for NB Steel.
Long-term financing sources should be used such as issuing bonds, preference shares, and
convertible bonds, to diversify its funding away from short-term sources.
(d)
AMIL BOND:
Enter number of remaining 4 [N] N= 4.00
coupon payments
Enter coupon payment 840,000 [PMT] PMT = 840,000
Enter redemption value 48,000,000 [FV] FV = 48,000,000
Enter yield to maturity (Kd) 8.44 [I/Y] I/Y = 8.44
Compute bond price [CPT] [PV] PV = -43,718,616
Amil Bond Price = $43,718,616
(e)
Period Bower Amil Portfolio cash
flows
Today’s Bond Price (16,212,221) (43,718,616) (59,930,837)
1 500,000 840,000 1,340,000
2 500,000 840,000 1,340,000
3 500,000 840,000 1,340,000
4 500,000 48,840,000 49,340,000
5 500,000 500,000
6 20,500,000 20,500,000
Use the same procedure as calculating a project’s Internal Rate of Return (IRR) to find the Yield to
maturity (kd) for uneven cash flow redeemable bond portfolio’s:
Enter cash flow - time period 0 [CF] 59,930,837 [+/-] [ENTER] CF0 = -59,930,837.00
Enter cash flow - time period 1 [ ] 1,340,000 [ENTER] C01 = 1,340,000.00
Enter frequency - time period 1 [ ] F01 = 1.00
Enter cash flow - time period 2 [ ] 1,340,000 [ENTER] C02 = 1,340,000.00
Enter cash flow - time period 3 [ ][ ] 1,340,000 [ENTER] C03 = 1,340,000.00
Enter cash flow - time period 4 [ ][ ] 49,340,000 [ENTER] C04 = 49,340,000.00
Enter cash flow - time period 5 [ ][ ] 500,000 [ENTER] C05 = 500,000.00
Enter cash flow - time period 6 [ ][ ] 20,500,000 [ENTER] C06 = 20,500,000.00
Compute IRR (yield to maturity) [IRR] [CPT] IRR = 5.00*
In this question (involving half yearly payments) the half yearly IRR (yield) = 5.00%
(f)
Yield to Maturity 10.00% 9.00%
(Discount rate)
The fund manager’s offer is better because it is a higher value by USD 1,270,480.
USE THE FINANCIAL CALCULATOR TO FIND THE MARKET PRICE (NPV) USING A YIELD TO
MATURITY (ANNUAL DISCOUNT RATE) OF 9.00%:
NOTE: THE ANNUAL 9.00% DISCOUNT RATE NEEDS ADJUSTING AS THE PERIODS ARE HALF
YEARLY !!!!
Renaissance has decided to issue a perpetual bond for RMB3 billion to fund the expansion plan given
the strong appetite for yields among institutional investors, such as pension funds, bond funds and
insurance companies in the market. The bond has a face value of RMB1,000 and makes 10% annual
coupon payments. The current one-year interest rate on the bond is 8%. There is a 35% probability
that the long-term interest rate will increase to 9% one year from now, and a 65% probability that it will
decline to 7%.
Required:
(a) Calculate the current price of the bond if the bond is non-callable.
(5 marks)
(b) Assume Renaissance decides to make the bond callable in one year with a call price at
RMB1,234 per bond.
(i) Explain when (if ever) Renaissance should choose to exercise the call option.
(4 marks)
(ii)
Calculate the current price of the callable bond and the current value of the call
option to Renaissance.
(5 marks)
Recommended solution
(a)
Or, the price of the bond in one year if interest rates drop to 7% will be:
P1 = RMB100 / 0.07
P1 = RMB1,428.57
The price of the bond today is the present value of the expected bond prices in one year + Interest
received end of year one discounted using the current one-year 8% interest rate:
Po = [(35% x RMB1,111.11) + (65% x RMB1,428.57) + RMB100] / 1.08
Po = RMB1,312.46
The current price of the non-callable bond will be RMB1,312.46
(b) (i)
If interest rates increase to 9% (the discount rate rises) the market price of the bonds will fall to
RMB1,111.11 as shown in part (a), lower than the redeemable RMB1,234 par value.
It is not worthwhile for the company to exercise (redeem / call) them and pay RMB1,234 when
the bonds are trading lower at RMB1,111.11
If interest rates decrease to 7% (the discount rate falls) the market price of the bonds will increase to
RMB1,428.27 as shown in part (a), higher than the redeemable RMB1,234 par value.
It is worthwhile for the company to exercise (redeem / call) them and pay RMB1,234 when the
bonds are trading higher at RMB1,428.27 - Renaissance could then issue new bonds at the new lower
rate if they wished to continue borrowing.
(b) (ii)
If interest rates increase to 9%, the company will not exercise (redeem / call) the bond and the
market price of the bonds in one year will be:
P1 = RMB1,111.11
If interest rates decrease to 7%, the bonds will be exercised (redeemed / called).
P1 = RMB1,234
The current value of the call option is the difference between the irredeemable (non-callable)
and redeemable (callable) prices above:
RMB1,312.46 - RMB1,195.36 = RMB117.10
THE RISK ADJUSTED WACC – ADJUSTING THE EQUITY BETA (LP 7.4.1.2)
Feb05 B3; Dec11 B5; Jun13 A3; Dec17 B8; Jun19 B12
The EXISTING WACC should ONLY be used as a discount rate for a new investment project if the
business risk and financial risk is the SAME.
If the business risk of the new project or financial risk CHANGES, the company's investors will
expect a different return to compensate them for this new level of risk and a RISK ADJUSTED
WACC must be used as the new discount rate.
This involves the technique of 'ungearing' and 'regearing' beta factors, recalculating the cost of
equity and WACC to reflect the risk of the new project.
Adjusting Betas
The formulae below links a companies ungeared beta asset (βa) with geared equity betas (βe) and
debt betas (βd):
E D(1− t)
β asset = β equity × + β debt ×
E + D (1 − t) E + D(1− t)
As the debt beta (βd) is beyond the M12 Syllabus, if we assume debt is risk free
(βd = 0), then the formulae becomes:
E
β asset = β equity ×
E + D (1 − t)
This is the formulae we need to know and use in the M12 exam!
Assumptions / Limitations:
• The same as the WACC, Market Values of E (Equity) and D (Debt) must be used in the
formulae for Beta adjustments and capital structures are assumed not to change in the
period under review.
• Difficult to find equity betas from companies with exactly the same business risk – different
growth opportunities, economies of scale / size, cost structure will all cause risk differences.
• In practice, debt is not entirely risk free, as higher D/E ratios carry higher risk of company
insolvency and the risk debt lenders may not receive their money (debt) back.
• As Beta’s use CAPM to produce cost of equity (Ke) – same CAPM limitations as earlier.
A travel company (Company A) currently has a debt equity ratio, by market values, of 2:5. The
corporate debt which is risk free yields 6% before tax. The beta value of the company's equity is
currently 1.1. The average returns on stock market equity are 12%, and the risk free rate is 6%.
Company A is now proposing to invest in a commercial property project which would involve
diversification into a new Industry.
On quoted the Hong Kong stock exchange Company B has been found who business is currently
involved in commercial property with the following information:
Is the investment in the same industry as our current business / Same Business Risk?
OR is it in a new industry (diversification) which has Different Business Risk?
E
ASSET BETA β asset = β equity ×
UNGEARED BETA E + D (1 − t)
(Take out Company B FR)
E + D (1 - t)
EQUITY BETA β equity = β asset ×
REGEARED BETA E
(Add in OUR companies FR)
4. Calculate Ke using CAPM
5. Calculate WACC
Recommended Solution
Step 1
Select an equity beta (βe) from a company (Company B) that undertakes similar business as the new
Investment for Company A. The equity beta is 1.59.
Step 2
Convert the geared equity beta (βe) for company B into an ungeared beta asset (βa) for the property
industry.
E
β asset = β equity ×
E + D (1 − t)
2
β asset = 1.59 × = 1.1778
2 + 1 (1 − 0.30)
Step 3
Convert this ungeared property industry beta asset back into a geared equity beta, which reflects the
company A’s own gearing level of 2:5.
E + D (1 - t)
β equity = β asset ×
E
5 + 2 (1 - 0.30)
β equity = 1.1778 × = 1.5076
5
Step 4
This is a project-specific beta for the firm's equity capital, and so using the CAPM, we can estimate
the project-specific cost of equity (Ke) as:
Step 5
The company is financed by a gearing ratio of 2:5 debt to equity, and so the project-specific / risk
adjusted weighted average cost of capital is:
Company A’s commercial project investment could now be appraised using NPV with 11.95%
WACC representing the appropriate cost of capital (discount rate).
ABC Toys Limited is a toy manufacturer listed on the Hong Kong Stock Exchange. Due to intense
competition, the board of directors plans to diversify into a completely new industry in order to reduce
the company’s business risk. As a result, a project called NewBus is under consideration.
The company uses NPV to evaluate the financial viability of NewBus and is looking for a proper
discount rate. Financing for this new venture will be from ABC’s existing pool of funds.
ABC Toy Limited has a pre-tax cost of bond of 4%. The bond has a nominal value of HK$46.75 million
and the last trading price was 107.14. Equity beta is 0.9. The debt is considered risk free. Market
value of one ordinary share is HK$5.8. The number of outstanding shares is 20 million.
Risk free rate is 4% per year and average return on the market is 12% per year. Assume tax rate is
16.5%. Assume the debt is risk free.
The company has identified another listed company, Co2 Limited, which is in a similar business as the
NewBus investment. Co2 Limited’s equity beta is 1.1, has a equity market value of HK$75 million, and
market value of debt is HK$25 million.
The investment in NewBus will not alter the current capital structure of ABC Toys Limited, which its
board considers to be optimal.
Required:
(a) Calculate the current weighted average cost of capital of ABC Toys Limited.
(5 marks)
(b) Calculate the cost of capital that ABC Toys Limited should use as a discount rate for
the NPV analysis of NewBus.
(8 marks)
(c) Advise the major limitations of the theories and principles used in calculating this
discount rate.
(6 marks)
Recommended Solution
(a)
Market Values
Ordinary Shares: 20 million x $5.8 = $116,000,000
Bonds: $46.75 million x 107.14% = $50,087,950
Total market value $166,087,950
(b)
Calculate NewBus project Equity Beta – Regear Asset Beta using ABC Ltd capital structure
E + D (1 - t)
β equity = β asset ×
E
$116m + $50.08795m (1 - 0.165)
β equity = 0.8605 × = 1.1707
$116m
(c)
The methods used to calculate the discount rate to evaluate NewBus's NPV are based on un-gearing
and re-gearing betas, CAPM and WACC and will have the following major limitations.
The same as the WACC, Market Values of E (Equity) and D (Debt) must be used in the formulae for
Beta adjustments and ABC Toys capital structure is assumed not to change during the NPV period
under review.
Difficult to find equity betas from companies with exactly the same business risk – The NewBus
project and Co2 Limited are likely to have different growth opportunities, economies of scale / size,
cost structure will all cause risk differences.
In practice, debt is not entirely risk free, as high D/E ratios carry high risk of company insolvency
and the risk debt lenders may not receive their money (debt) back.
It is difficult to estimate the expected market return and determine the risk-free rate of return.
The CAPM is only a single period model - the dynamic market and the economic environment
change the values in the model.
There may be errors in the statistical analysis used to calculate Co2 Limited beta and betas (risk)
change over time.
We now need to ask the question whether or not an optimal capital structure exists, and if so what
mix a company should achieve between debt and equity finance?
Directors have a duty to maximise shareholder wealth and therefore need to seek an optimal
financing mix.
• Debt less risky than equity, therefore the return required by investors is lower.
Capital Income Relative Risk Required
Repayment / Security Interest / Dividends Levels Return
Debt Lenders normally Known “Fixed” amount
require security + compulsory nature Lower Kd say ≈ 10%
Equity Could lose everything No guaranteed payment
if company is bankrupt Higher Ke say ≈ 15%
• Tax relief on interest payments (tax shield) - the company gets tax relief on interest
payments but not on dividends e.g. Kd 10% (1-0.165) = KdAT 8.35% (cost of debt
from the company’s viewpoint is after tax)
So we might expect that increasing proportion of debt finance would be a good idea and would reduce
WACC.
BUT:
• Debt = Fixed cost commitment (interest must be paid before dividends) = finance risk.
So increasing gearing (proportion of finance in the form of debt) increases the cost of equity and
that would increase WACC.
Equity holders only see small risk increases as gearing (proportion of debt to equity) rises, so the
cheapness of the after tax debt outweighs the small increase in Ke resulting in a lower WACC.
Equity holders become increasingly concerned with the increased volatility of their returns
(debt interest must be paid before dividends) plus financial distress (bankruptcy) worries. These
concerns equity holders have trade-off the cheapness of the extra debt so the WACC starts to
rise as gearing increases.
Serious financial distress (bankruptcy) risks worries both equity and debt holders alike so both Ke
and KdAT rise with increased gearing, resulting in the WACC rising further.
where:
CONCLUSION
If you can reduce the WACC this results in a higher market value/net present value of the company
and therefore increases shareholder wealth.
CONCLUSION
If it is possible to reduce the WACC by changing the gearing ratio, Directors have a duty to achieve
this optimal gearing level / capital structure, as this maximises the value of the company and
shareholder wealth.
PROBLEM
There is no method, apart from trial and error (trying different capital structures and evaluating their
effects) to locate the optimal point.
Jasmine & Co is a garment manufacturing company in Hong Kong. The CEO of Jasmine & Co is in the
final stage of negotiations to acquire a logistic company, TXP, because he believes that this
acquisition will allow his company to gain better control of the cost and timing for distributing products
to customers in 18 different countries.
If the deal is successfully closed, he plans to operate TXP as a separate entity from Jasmine & Co. He
is now working with his CFO on the future capital structure of TXP. The cost of equity and cost of debt
of TXP under different gearing levels are projected below by an external consultant:
Required:
(a) Assume that the free cash flow for TXP is $310M per annum and a stable growth rate of
2.2%, what will be the optimal level of capital structure for TXP?
(4 marks)
Recommended solution
The optimal level of capital structure is reached when the gearing level is 45%, as this minimises
the weighted average cost of capital (WACC) at 7.0925%
Free Cash Flow to the Firm (FCFF) using a constant growth perpetuity formula:
At the 45% gearing level, the firm value will be maximised at $6,476M
BASIC IDEA
MM said the purpose of a company is to take cash from providers of long-term funds, invest in
positive NPV projects and repay the future net inflows back to the fund providers in the form of
dividends and interest.
MM asked a simple question: ‘does capital structure affect a company’s efficiency in turning
project cash flows back into cash in the hands of providers of the long-term funds?’
BASIC PRINCIPLES OF MM
Suppose that two companies are identical in all respects other than capital structure – consider their
efficiency in generating cash for the long-term fund providers:
Company A Company B
All equity financed Partly debt financed
(geared)
$ $
Operating profit 100,000 100,000
Interest on debt Nil (30,000)
Now ask yourself a question: if you could own all the equity of Company A or all the equity and all
the debt of Company B which would you prefer?
Rational investors would be indifferent between the two companies. This tells us that logically the
two companies must have the same value on the market as they ultimately have the same
efficiency in generating spending power.
Or using symbols:
Vu = Vg
(u for ungeared) (g for geared)
A number of criticisms were levelled at MM's no tax theory, but the most significant was the
assumption that there were no taxes. Since debt interest is tax-deductible the impact of tax
could not be ignored.
In 1963 MM revised their theory to reflect the fact that the tax gives tax relief on interest payments.
Let us take the two companies from 1958 and put them into a 1963 world, this time including tax but
otherwise with the same underlying assumptions:
Company A Company B
All equity financed Partly debt financed
(geared)
$ $
Operating profit 100,000 100,000
Interest on debt Nil (30,000)
This time if you could obtain all of the equity of the equity company or all of the debt and all of the
equity of the geared company which would be preferable?
Both companies are identical – but this time the geared company is more efficient in terms of
generating cash as it provides $88,450 in total from its projects compared to $83,500. So company B
is preferred.
The difference in total cash out of $4950 between the two companies is simply the difference in the tax
bill and this is caused by the interest in the geared company being a tax allowable expense.
Therefore:
Annual cash flow advantage = Interest paid on debt x Tax rate
for geared company
(the “tax shield”)
The examiner will not expect you to prove any MM formulae’s, the following is included only for
illustration!!!
The advantage of debt over the life of the company (to perpetuity) could be calculated as follows:
However we do not need to know the Bondholders required rate of return because:
This means:
We can now link the values of equivalent geared and ungeared companies via the value of the tax
shield.
MM argued that:
Vg = Vu + DT
Where: Vg = value of debt plus equity in a geared company (= the total value of a geared company)
T = tax rate
DT is the present value of the 'tax shield' on the company's debt to perpetuity.
This formula shows that with higher amounts of debt capital in the capital structure, the total value of
the company is higher because of the present value of the tax shield.
This supports MM’s argument that a company should be geared as highly as possible (up to 99.99%)
to maximise its total market value.
Required:
(a) Based on MM theory, what would be the value of an identical company that is all-equity
financed?
(b) Based on MM theory, what would be the value of the company, if it replaced some of its
equity capital with an additional $2 million of debt capital (market value)?
Answer
(a)
Vg = Vu + DT
$14,000,000 = Vu + $660,000
The all-equity financed company is worth $660,000 less than the equivalent geared company because
of the Present Value of the tax shield on debt.
(b)
Vu = $13,340,000
Vg = Vu + DT
Alternatively:
The increase in value of the geared company which is currently worth $14m is calculated as the tax
shield on the additional debt $2m × 16.5% = $330,000, thereby increasing the value to $14,330,000.
Another MM formula relates the cost of equity in an ungeared company and the cost of equity in a
company that is identical in every respect except that it has debt capital in its capital structure.
MM argued that:
Keu is the cost of equity in an identical but ungeared company - can be calculated using
CAPM and an asset beta (ungeared beta) adjustment.
Vd, Ve are the market values of debt and equity respectively in the geared company
MM argue the cost of equity increases linearly as the value of debt relative to the value equity
increases. In other words, the cost of equity increases as the level of gearing increases.
• The market value of the equity capital in the geared company is $25 million
• The market value of the debt capital in the geared company is $20 million
Required:
Answer
Where: WACC is the after-tax weighted average cost of capital in a geared company
L is the gearing ratio (or leverage ratio), measured as the market values of debt / (debt +
equity) in the geared company i.e. Vd / (Vd + Ve)
MM argue by increasing gearing (increasing the amount of debt finance) this results in a reduction in
the WACC and an increase in the value of the company.
Required:
Answer
= 0.1112 or 11.12%
By comparison:
= 0.1112 or 11.12%
CONCLUSION
MM argue by increasing gearing (increasing the amount of debt finance) this results in a reduction
in the WACC and an increase in the Value of the company.
In a perfect capital market the optimal capital structure is 99.9% gearing !!! The company should
use as much debt as possible. This is demonstrated in the following diagrams:
PROBLEM
MM theories are at odds with the traditional trade-off theory of a U-shaped WACC.
No company in reality has extreme 99.9% gearing levels due to market imperfections.
MARKET IMPERFECTIONS
KEY PRACTICAL ARGUMENTS AGAINST ADOPTING THE CONCLUSIONS OF MM
BANKRUPTCY COSTS / FINANCIAL DISTRESS
As gearing increases so does the possibility of bankruptcy. If investors become concerned, this
will increase both the Kd and Ke, increasing the WACC and reducing the share price (company
value).
TAX EXHAUSTION
After a certain level of gearing companies will discover that they have no tax liability left against
which to offset interest charges. Kd x (1 - T) simply becomes Kd.
BORROWING/DEBT CAPACITY
High levels of gearing are difficult because companies run out of suitable assets to offer as security
against loans.
KLM is a Hong Kong listed company in the manufacturing business and has been profitable since its
establishment about 10 years ago. The Board has adopted a very conservative capital structure of
zero debt. The main reason is that the cash flow of the Company has not been very steady when it
was initially established. Lately, the company has developed a stable customer base resulting in stable
earnings and cash flow. Currently, KLM has authorised and issued share capital of $500 million.
Market value and book value of equity are $1.5 billion and $600 million respectively.
With an established customer base and better quality of earnings, the Company is looking for an
expansion opportunity and plans to raise $500 million for a capital investment project that carries
similar risks to KLM and the Board considers issuing debt at a fixed interest of 5.5%. It is noted that
introducing debt in the capital structure will impact its cost of equity and overall cost of capital as well
as increase the return on equity. At the same time, debt will increase financial risk. As such, KLM
needs to carefully consider the various implications before making a decision.
The following data applies to KLM: Tax rate is 16.5%, risk free rate is 5%, and market return is 10.5%.
Company equity beta is 0.8.
Required:
(a) Calculate the cost of equity and weighted average cost of capital (“WACC”) after the
debt issue.
(5 marks)
(b) After the debt issue, assume the market values of equity and debt now are $1.5 billion
and $500 million respectively, i.e. a debt to equity (D/E) ratio of 1:3. The equity beta of
KLM, due to gearing, has increased to 1.023.
KLM then plans to diversify by investing into a service company, which is unrelated to
its core business. This service industry carries an average equity beta of 0.95 and
average D/E ratio is 1:4. KLM expects financing such diversification will not alter its D/E
ratio of 1:3.
(i) Calculate the ungeared beta of the service company in which KLM plans to
invest.
(3 marks)
(ii) Calculate a suitable cost of capital for investment evaluation in this scenario
and explain your rationale.
(7 marks)
(c) MM suggests a firm should gear up as much as possible to maximise its value. Explain
why in practice a company will not do so.
(3 marks)
Recommended solution
(a)
Cost of equity based on MM
Keg = Keu + (Keu – Kd) (Vd / Ve) (1 – T)
= 0.094 (W1) + (0.094 – 0.055) x (500/1500) x (1 – 0.165)
= 10.49%
(W1) Keu using CAPM
Keu = Rf + β x (Rm - Rf)
= 5% + 0.8 x (10.5% - 5%)
= 9.4%
WACC based on MM
WACC = Keu (1 – TL)
= 0.094 x [1 – (0.165) x (500/2000)]
= 9.01%
(b) (i)
Ungeared (Asset) Beta
E
β asset = β equity ×
E + D (1 − t)
4
= 0.95 × = 0.7859
4 + 1 (1 − 0.165)
(b) (ii)
WACC based on MM
WACC = Keu (1 – TL)
= 0.0932 (W2) x [1 – (0.165) x (500/2000)]
= 8.94%
(W2) Keu using CAPM
Keu = Rf + β x (Rm - Rf)
= 5% + 0.7859 x (10.5% - 5%)
= 9.32%
KLM should use 8.94% as the cost of capital for investment evaluation since this cost considers
the business risk of the service industry in which KLM plans to invest, and also the capital structure of
KLM.
Using KLM’s original WACC calculated in (a) is not correct as the original business risk is different.
(c)
In reality companies will not gear up a firm as much as possible because as debt increases so
does the possibility of bankruptcy, worrying investors and increasing Kd, Ke, and WACC and
reducing the share price (company value).
In order to safeguard their investments lenders will often impose restrictive conditions in the loan
agreements such as restricting the level of additional debt that can be raised.
After a certain level of gearing companies will discover that they have no tax liability left against
which to offset interest charges. Kd x (1 - T) simply becomes Kd.
High levels of gearing are difficult because companies run out of suitable assets to offer as security
against loans.
The pecking order theory says Directors choice of finance is based on the quickest, easiest and
cheapest methods to establish the capital structure.
• The degree of questioning and publicity associated with debt is usually significantly less
than that associated with a share issue.
• Moderate issue costs.
• Perception by stock markets that it is a possible sign of problems – Directors will only
issue shares when they believe the firm’s shares are over-priced.
• Extensive questioning and publicity associated with a share issue.
• Expensive issue costs.
CONCLUSION
The Pecking order theory is an explanation of what the Directors actually do, rather than what they
should do (which is minimising the WACC, and maximising the value of the company and
shareholder wealth).
PROBLEM
Following the pecking order theory fails to take into account the actual cost of financing, effects on
company / shareholder wealth or even how the length of the investment opportunities need to be
matched to the length of finance.
(a) EFG Limited, a Hong Kong listed company, has 200,000 bonds outstanding that are
selling at 97.5% of face value of $1,000 each. Bonds with similar characteristics are
yielding 6.75% pretax. The company also has 2,250,000 shares of 7% preferred stock
(par value = $100) and 7,500,000 shares of common stock outstanding. The preferred
stock sells for $50 a share. The common stock has a beta of 1.34 and sells for $62 a
share. The risk free rate is 2.8% and the return on the market is 11.2%. The corporate
tax rate is 16.5%.
(ii) Given the cost of debt is generally lower than the cost of equity, why will a
company only leverage (borrow) to a certain level instead of exhausting its
borrowing power before going to equity?
(3 marks)
(b) EFG Limited plans to continue further investment to expand its business. One of the
directors suggested to use retained earnings first, followed by debt before issuing new
shares to finance investment. This priority is based on increasing cash issuing cost.
EFG Limited has been in business for only a few years and it considers its current
capital structure as optimal. It has not accumulated substantial amount of cash. Due to
its success, its share price is at an all time high.
(i) Explain the capital structure theory on which the director based his suggestions
and the characteristics of a company using this theory in managing capital
structure.
(5 marks)
(ii) Comment on the director’s capital structure theory in (i) from the perspective of
its implications for company valuation, capital budgeting analysis, actual cost
of financing and financial flexibility.
(8 marks)
Recommended Solution
(a) (i)
Market Values Weighting %
Bond: 200,000 x $1,000 x 97.5% = $195,000,000 25.243%
Preferred Stock: 2,250,000 x $50 = $112,500,000 14.563%
Common Stock: 7,500,000 x $62 = $465,000,000 60.194%
Total market value $772,500,000 100.000%
WACC
WACC = (5.636% x 25.243%) + (14% x 14.563%) + (14.056% x 60.194%)
WACC = 11.92%
(a) (ii)
At low levels of debt the cost of debt is cheaper than cost of equity, but as the company increases
the level of debt equity holders become increasingly concerned with the increased volatility and risk of
their returns.
As debt interest is paid first this reduces the cash available to pay dividends, which increases the risk
and cost of equity trading off the cheapness of the extra debt so at higher levels of debt the WACC
will rise as the level of debt increases.
As such, a company would normally not borrow up to their maximum debt level but instead seek
to find the optimum level of capital structure, the mix of debt and equity which minimises the WACC
and maximises the company value.
(b) (i)
The director’s suggestion is based on the Pecking Order Theory which suggests the order of
financing should be to use retained earnings first, followed by debt then finally by issuing new shares.
This theory is based on the relative effects the three sources can have and the fact issuing costs
increase the further you move down the pecking order.
When a company uses this approach, there is no search for an optimal capital structure which
should be to minimise the WACC and maximise company value.
The pecking order theory fails to take into account the actual cost of financing, effects on company /
shareholder wealth or how the length of the investment should be matched to the length of the finance.
The theory explains what the directors actually do rather than what they should be aiming to do
which is to find the optimal capital structure, minimise the cost of capital and maximise the market
value of the company and shareholder wealth.
(b) (ii)
In terms of company valuation the Pecking Order Theory will save the company issuing costs, but
the problem is the theory does not search for an optimal capital structure minimising the cost of capital.
As the cost of capital will be higher than at the optimal level, this higher cost will reduce the value of
future project cash flow returns which in turn will reduce the value of the company and its share price.
If the WACC is used as the discount rate for capital budgeting analysis, a higher WACC and
discount rate will cause perfectly acceptable profitable projects to be rejected.
As EFG Limited plans to continue further investment to expand its business a higher WACC and
discount rate will limit potentially good future project opportunities.
The actual cost of financing using debt and equity is constantly changing and the Pecking order
theory fails to take into account opportunities to be gained in raising finance at lower costs.
For instance interest rates affect the cost of debt and if rates are low this can represent a good time to
borrow cheap debt, increase the companies level of debt and reduce the WACC.
If the share price is high as in the case of EFG then it indicates a good time to issue further shares as
the company will receive more value for the sale of each share.
The pecking order theory as does not take into account the financial flexibility certain finance
sources can have, for instance with debt it can be repaid when it is not needed.
Equity can also be seen to be flexible too since the amount of dividends can be decided by the
Directors and are not fixed like the debt interest payments.
(EBIT – I ) x (1 - T) (EBIT - I) x (1 - T)
=
S1 S2
FinSmart Limited (“FinSmart”) is considering alternative ways to finance an exciting HK$30 million
acquisition in order to capture the potential of a new market for its products. FinSmart uses a rolling
forecast on cash needs and, based on the latest estimate, it will be able to deploy up to HK$10 million
of its current cash balance to partially finance the investment.
FinSmart currently has a HK$5 million, 5.5% loan due in two years’ time. The number of shares issued
and outstanding is 40 million.
It is expected the EBIT in the next three years will remain stable at HK$18 million. Tax rate is 16.5%
Required:
(a) Calculate the breakeven EBIT that will result in the same earnings per share under both
options.
(6 marks)
(b) Which option should FinSmart adopt? Explain your rationale and support with
calculation.
(3 marks)
Recommended Solution
(a)
The calculation of Breakeven EBIT is as follows:
(EBIT – I) x (1 - T) (EBIT - I) x (1 - T)
=
S1 S2
Financing Method: S1 S2
Debt Equity
HK$ HK$
Breakeven EBIT $13,475,000 $13,475,000
Interest ($1,475,000) ($275,000)
$12,000,000 $13,200,000
Tax @ 16.5% ($1,980,000) ($2,178,000)
Earning after tax $10,020,000 $11,022,000
(b)
As FinSmart’s expected EBIT of HK$18m is higher than the Breakeven EBIT of HK$13.475m, to
maximise EPS the company should issue debt as shown below:
Financing Method: S1 S2
Debt Equity
$ $
Expected EBIT $18,000,000 $18,000,000
Interest ($1,475,000) ($275,000)
$16,525,000 $17,725,000
Tax @ 16.5% ($2,726,625) ($2,924,625)
Earning after tax $13,798,375 $14,800,375
The company should choose debt finance as this maximises EPS and return on equity (ROE).
Deciding whether to invest in a new project can be one of the most strategically rewarding, risky
and expensive decisions a company can make.
Capital Budgeting Analysis (CBA) is used to evaluate potential long-term risky capital
investments using a number of ‘PROJECT APPRAISAL TECHNIQUES’
Enigma Ltd has the opportunity to invest in two mutually exclusive projects with the following initial
costs and returns:
A B
($000s) ($000s)
Initial investment (90) (20)
Cash flows Yr 1 40 10
Yr 2 30 8
Yr 3 20 6
Yr 4 20 4
Yr 5 20 4
Disposal value Yr 5 4 2
Required:
Which project should be recommended?
It indicates to some degree the liquidity (cash flow risk) of the project
Decision criteria
• Only select projects that pay back within the acceptable period (e.g. 3 years)
• If there is more than one project you choose between (mutually exclusive) select the
project with the shorter payback period.
Advantages
1. Simple to understand and calculate.
2. A simple measure of liquidity risk, the longer the payback, the higher the risk.
3. May be important to companies with limited cash resources for budgeting purposes.
4. Uses cash flows that are less open to manipulation than profits.
5. Emphasises cash flow in the early years.
Disadvantages
1. It does not consider the time value of money.
2. There is no measure of return
3. Only cash flows up to payback are considered.
Look to see if a method is mentioned in the exam question, otherwise it is common to use the
“average investment” method.
Average Investment
Decision criteria
• The ARR for an investment is compared to the required return or a target (often related
to a company ROCE or WACC). If the ARR is greater we will accept the investment.
• If two projects are mutually exclusive we select the project with the greater ARR.
Advantages
1. Widely used.
2. Simple to understand and calculate.
3. Can be calculated from available accounting data.
4. It considers the whole of the investment and is some measure of (accounting) return.
Disadvantages
1. It does not consider the time value of money.
2. It is based upon (subjective) accounting profit.
3. It is not a $ absolute measure of return, but a relative % measure.
The application of the idea that there is a TIME VALUE OF MONEY. What this means is that money
received will have more worth than the same amount received at some point in the future.
Why would you rather have $100,000 now rather than in one year’s time?
Reasons: 1. You can INVEST $100K today to earn a larger future return
2. Because of INFLATION $100K buys more today than in the future
3. Receiving the money today reduces RISK and uncertainty
If a project has a positive NPV then it should be accepted because the project is generating a
higher return than can be earned elsewhere. If a project has a negative NPV then the project
should be rejected. The capital should be invested elsewhere.
The discount rate represents is usually called the cost of capital or required return.
Advantages
1. It does consider the time value of money.
2. NPV is a $ absolute measure of return.
3. It is based on cash flows not profits.
4. It considers the whole life the project.
5. It should lead to the maximisation of shareholders wealth.
Disadvantages
1. Not easily explained to managers.
2. Requires that the cost of capital is known.
3. Relatively complex.
Year 0 1 2 3 4 5
$000 $000 $000 $000 $000 $000
Receipts (or cost savings) X X X X
Payments:
Wages (X) (X) (X) (X)
Materials (X) (X) (X) (X)
Variable / Fixed overheads (X) (X) (X) (X)
Administration / Distribution expenses (X) (X) (X) (X)
TAXABLE CASH FLOWS X X X X
RELEVANT CASH FLOW (CF): Future cash flow arising as a direct result of the decision
NOTE: IGNORE ALL FINANCING CASH FLOWS (INTEREST CHARGES, LOAN
REPAYMENTS, DIVIDENDS, ETC.) AS THESE ARE ALREADY INCLUDED IN THE COST
OF CAPITAL DISCOUNT RATE.
INFLATION (i)
Inflation is a general increase in prices leading to a general decline in the real value of money.
In times of inflation, investors will require a return made up of a Real return for the use of their
funds plus an additional return to compensate for inflation.
This overall required return is called the Money or Nominal rate of return.
Money (Nominal) and Real rates are linked by the formula:
(1 + n) = (1 + r) x (1 + i) or
(1 + r) = (1 + n) / (1 + i)
where: n = Money (Nominal) discount rate
r = Real discount rate
i = General inflation rate
TAXATION (t)
GOOD: Investment in non-current assets (i.e. machinery) attracts tax relief in the form of tax
allowable depreciation (TAD) or sometimes called capital allowances (CA) – these should be
treated as tax savings (cash inflows).
NOTE: BOTH STRAIGHT-LINE AND REDUCING BALANCE METHODS CAN BE TESTED.
LOOK CARFEULLY FOR THE METHOD IN THE QUESTION, OTHERWISE ASSUME
STRAIGHT-LINE.
BAD: Additional profits or net trading revenue leads to an increase in tax paid - a cash outflow.
UGLY: Tax payments are delayed. In some exam questions this is dealt with by delaying them
by one year.
NOTE: READ THE EXAM QUESTION CAREFULLY, IS THE TAX DELAYED? OTHERWISE
ASSUME NO DELAY.
ABC plc provides the following projected data for the next ten years, excluding inflation.
Year: 0 1 2 3 – 10
Net cash flows ($m) (1,700) 100 200 300
The rate of inflation is 3% and the WACC is 11.24%
Calculate the present value of the cash flows over the 10-year period.
Real Method: Cash flows are in real terms, simply deflate the money discount rate to get the real rate.
NPV +$42m
*Student note: As annuities (a series of equal cash flows) and perpetuities (equal cash flows that arise
forever) assume the first payment is in one year’s time, when you apply the formulae they
automatically discount back one year as seen above.
Money Method: Calculate the money cash flows by increasing them each year for inflation and
discount using the money discount rate.
Net cash flows (1,700) 103 212 328 338 348 358 369 380 391 403
Discount factor x x x x x x x x x x x
@ 11.24% 1.000 0.899 0.808 0.726 0.653 0.587 0.528 0.474 0.426 0.383 0.345
Present value (1,700) 93 171 238 221 204 189 175 162 150 139
NPV +$42m
Both methods give the same answer, but as there is one rate of inflation and cash flows are given in
real terms (excluding inflation) in this case the real method would be the recommended approach.
A company is considering whether or not to purchase an item of machinery costing $400,000 payable
immediately. It would have a life of four years, after which it would be sold for $50,000.
The machinery would create annual cost savings of $140,000.
The company pays tax one year in arrears at an annual rate of 16.5% and can claim tax-allowable
depreciation on a 25% reducing balance basis. The company's cost of capital is 8%.
Should the machinery be purchased?
Solution
Note: Assume the first Tax Allowable Depreciation (TAD) claim is made in Year 1, unless told
otherwise!
Tax Savings from Tax Allow Depreciation (W1) 16.5 12.4 9.3 19.6
Both methods give the same answer, but as Method 1 is quicker and is the recommended
approach for domestic HK$ projects in the exam!
The relevant cash flows are the incremental changes from one year's requirement to the next.
So for example, if a project lasts for five years with a $200,000 working capital requirement at the end
of year 1, rising to $300,000 at the end of year 2, the DCF calculation will show $200,000 as a year
1 cash outflow and $100,000 (300,000 – 200,000) as a year 2 cash outflow.
Working capital is assumed to be recovered at the end of the project unless the examiner tells you
otherwise - this will be shown by a $300,000 cash inflow at year 5.
Assume there are no associated tax effects for working capital flows.
The IRR may be calculated manually by linear interpolation or using a financial calculator.
Year Project A
Discount Factors Cash Flows Present Value
@ 20%
($000) ($000)
0 1.000 (90) (90)
1 0.833 40 33.32
2 0.694 30 20.82
3 0.579 20 11.58
4 0.482 20 9.64
5 0.402 24 9.65
NPV = -$5.00k
14.72
IRR (A) ≈ 10 + × ( 20 − 10) = 17.47%
14.72 + 5
IRR (B) ≈ 10 +
6.67
× ( 20 − 10) = 23.4%
6. 67 − 1 .696
Decision criteria
• If the IRR is greater than the cost of capital accept the project.
• If the projects are mutually exclusive choose the higher IRR (but be careful as this
can conflict with the NPV choice – you should always choose the higher NPV
to ensure you maximise shareholder wealth).
Calculating using linear interpolation only gives a rough IRR estimate as the model assumes a
straight-line relationship when in actual fact the relationship is curved. The only way to accurately
calculate IRR (arrive at the same answer as the M12 Examiner!) is using a financial calculator.
Enter cash flow - time period 0 [CF] 90 [+/-] [ENTER] CF0 = -90.00
Enter cash flow - time period 1 [ ] 40 [ENTER] C01 = 40.00
Enter frequency - time period 1 [ ] F01 = 1.00
Enter cash flow - time period 2 [ ] 30 [ENTER] C02 = 30.00
Enter cash flow - time period 3 [ ][ ] 20 [ENTER] C03 = 20.00
Enter cash flow - time period 4 [ ][ ] 20 [ENTER] C04 = 20.00
Enter cash flow - time period 5 [ ][ ] 24 [ENTER] C05 = 24.00
Compute IRR [IRR] [CPT] IRR = 17.12
Disadvantages
1. IRR is not a $ absolute measure of return, but a relative % measure.
2. Interpolation only provides a rough estimate as it assumes straight-line and is not accurate.
3. Non-conventional cashflows may give rise to multiple IRRs.
The capital investment decision is a long-term decision. When forecasting future cash flows there will
always be an element of risk and uncertainty. This makes any result of our decision uncertain i.e.
a positive or negative NPV may not be a reliable estimate of the attractiveness of a project.
The method shows how responsive the project's NPV is to changes in key variables that are used
to calculate the NPV such as:
• Initial investment
• Discount rate
• Future expected sales or revenues
• Cost base per annum
A NPV is calculated for a project - this NPV is then altered by changing a single variable of the
sum. The idea is to see by how much the value must change before the decision changes from
accept to reject.
Key idea: A single key variable is changed in isolation from the original sum:
NPV
Sensitivity % =
PV of flow under considerat ion
Management need to pay special attention to the variable that causes the most
change in the NPV, because a minor error in the estimation will result in an incorrect
NPV and final decision.
An investment of $40,000 in year 0 is expected to give rise to annual contribution (annual sales less
annual variable costs) of $25,000 and annual fixed cost of $10,000 for each of years 1 to 4; the
discount rate is 10%
Required:
(b) By how much would the values have to change for the decision to alter for:
(i) Initial investment?
(ii) Sales volume?
(iii) Fixed costs?
(iv) Discount rate?
Recommended solution
(a)
Year Cash flow Discount factors Present value
($) @ 10% ($)
7,550
(b) (i) Sensitivity to initial investment = = 18.875%
40,000
7,550
(ii) Sensitivity to sales volume = = 9.53%
79,250
*Student note: when sales volume changes it will affect both sales and variable costs
(= annual contribution)
7,550
(iii) Sensitivity to fixed cost = = 23.8%
31,700
(iv) To calculate the discount rate needed to make the NPV go down to 0 (which is the point
at which we change our decision from accept to reject) you need to calculate the Internal
Rate of Return (IRR) – covered in detail in the next section.
Enter cash flow - time period 0 [CF] 40,000 [+/-] [ENTER] CF0 = -40,000.00
Enter cash flow - time period 1 [ ] 15,000 [ENTER] C01 = 15,000.00
Enter frequency - time period 1 [ ] 4 [ENTER] F01 = 4.00
Compute IRR [IRR] [CPT] IRR = 18.45
The discount rate needs to change from 10% to 18.45% which is a 84.5% sensitivity change.
Scenario analysis can help the company identify and understand future risks by looking at various
different scenarios, such as:
• Best case scenario – All variables set to the best possible results.
• Worst case scenario – All variables set to the worst possible results.
• Multiple scenarios – If one or more interdependent variables are adjusted.
In this situation then we may use an ‘arithmetic mean’ called an Expected Value (EV) = Σpx
Where: p = the probability of an outcome
x = the value of an outcome
Large projects requiring significant investment will need to be approved by the ‘Board of Directors’.
To reduce the risks of intentional (or unintentional) poor, unethical or biased misconduct project
mismanagement actions the ‘Board of Directors’ should consider:
• Making staff aware of the ethical duties and conduct expected during the various project
stages, especially objectivity and the need to avoid conflict and bias.
• Find an independent advisor who is an expert in appraising certain specialised parts of the
project or areas involving assessment and uncertainty.
• Ensure the project is focused on creating long term shareholder wealth rather than
achieving any short-term management performance measurements.
• Consider non-financial and qualitative factors, such as customer satisfaction, market and
competitor reactions, strategy and business brand image.
• Carefully manage the project paying particular attention to the areas of project planning
and project risk management.
• Carefully assess whether the company has sufficient resources, particularly in areas such as
human resources and financial resources.
• Before approval ‘Board of Directors’ should inspect projects carefully and objectively to
ensure assumptions are reasonable and well supported by appropriate research.
• On completion perform a ‘Post project review’ to identify and understand what went well and
what went badly in the project and to feedback lessons learned with the aim of improving
future projects.
Recommended solution
(a)
A project is financially acceptable if the Internal rate of return (IRR) of 12.5% is greater than the
Company’s Weighted Average Cost of Capital (WACC).
Since the 12.5% IRR is greater than the current WACC of 12% Company WXX can currently
accept the project.
Since the CFO is trying to lower the WACC by issuing 25% debt, the project would be expected to
remain acceptable as the IRR should remain greater than the WACC.
With 25% debt, the WACC (based on MM) reduces to 11.51%, the project remains acceptable.
WACC = Keu (1 – TL) = 0.12 x [1 – (0.165) x (25/100)] = 11.51%
*Student note: Although the requirement does not specifically mention Modigliani and Miller theory,
there are hints in the scenario the examiner wants you to use this method such as the company being
an “all equity company” and part (b) asking about MM theory.
(b)
According to MM theory without taxes the capital structure is irrelevant and based on MM theory
with taxes Company WWX would need to be financed using 99.99% debt to be considered as
having an optimal capital structure.
However, as MM theories have been proven to be incorrect and Company WWX’s D/E ratio with
debt is 33.33% (25/75) very close to the industry ratio of 30%, this might be considered an optimal
capital structure in reality.
(c)
In order to convince the Board, the CFO can apply the FRICT framework as follow:
Flexibility
Company WWX currently has a lot of flexibility, being able to easily use retained earnings, equity
as well as the current opportunity to raise debt from a bank loan as they are in a sound financial
situation with zero debt.
Risk
The financial risk of WWX is very low since company has no debt and enjoys strong profitability
and cash flows so should be able to easily take on 25% debt with little impact on their share price
and shareholders.
Income
Since Company WWX has strong profitability they should be able to increase their earnings per
share (EPS), dividends per share (DPS) and return on equity (ROE) by taking on additional debt
as their EBIT should be above their EBIT indifference breakeven point.
Control
Raising debt should not impact the companies nor shareholders control since the bank has
indicated that no unusual covenant will be imposed due to the sound financial situation WWX
enjoys with strong profitability and cash flows.
Timing
Interest rates on the bank loan might increase in the future if it is not a fixed rate, however using
debt will bring WWX closer to the industry's D/E average of 30% which might be considered an
optimal capital structure.
WXY Growth Limited is considering a HK$20 million investment project to support the launch of a new
product. The marketing department estimates that the demand will be promising, but cannot identify
accurate future sales figures at this stage due to uncertainty from the reaction of the competitors after
launch. Best estimates at this stage is that there is a 60% chance of 50,000 units and a 40% chance
of 80,000 units selling at launch.
It is also estimated that sale starts to grow after the end of the first year of launch at 10% per year for
the next two years until end of year three and then will remain constant until the end of project
economic life as the market matures. Total project economic life is estimated to be five years.
The marketing and accounting departments form a project team and come up with the following
relevant information:
• Unit sales price is HK$250 and the estimated price will be price inelastic due to its unique
features.
• Initial fixed operating cost including depreciation is HK$4.3 million per annum and is assumed
constant as efficiency will offset future inflation.
• The project will also need an incremental working capital of HK$120,000 initially and
HK$20,000 at the beginning of the second year.
• Weighted average cost of capital of the company is 13%. The post-tax cost of capital of a
similar project is 15%.
• The HK$20 million investment can be depreciated using straight line method for both
accounting and tax purposes with no residual value.
• It is expected the project can be liquidated at the end of investment period for HK$1 million,
before tax.
• Tax savings from depreciation occur at the same year when allowance is recognised.
Required:
(a) Calculate the net present value (“NPV”) for this project and advise whether it should be
accepted.
(13 marks)
(b) The Company needs to make a number of estimation of the variables to arrive the
answer in (a). In practise, some variables affect the NPV more than the others. Explain
one method which can help the management identify such key variables. Calculation is
not required.
(5 marks)
Recommended solution
(a) Net Present Value
Year 0 1 2 3 4 5
$000 $000 $000 $000 $000 $000
Contribution from sales (W1) 6,200 6,820 7,502 7,502 7,502
Fixed costs (excluding depre.) (300) (300) (300) (300) (300)
TAXABLE CASH FLOWS 5,900 6,520 7,202 7,202 7,202
Tax Savings from TAD (W2) 660 660 660 660 495
Workings:
(W1) Contribution from sales in $000’s
Year Expected number of units sold x SP x contribution margin
1 $6,200 (60% x 50,000 + 40% x 80,000) x $250 x 40%
2 $6,820 Y1 Contribution $6,200 x 10% growth rate
3 $7,502 Y2 Contribution $6,820 x 10% growth rate
4 & 5 $7,502 No growth
(b)
The method that can help management identify key variables that affect the NPV is known as
sensitivity analysis.
The method shows how responsive the project's NPV is to changes in the variables that are used to
calculate the NPV such as the initial investment, discount rate, future expected sales or costs.
A NPV is calculated for a project just like in part (a), then next the NPV is then altered by changing a
single variable of the sum.
The idea is to see by how much the value must change before the decision changes from accept
to reject.
Management need to pay special attention to the variable that causes the most change in the NPV,
because a minor error in the estimation will result in an incorrect NPV and final decision.
These figures are based on current (year 0) prices. Both inflation and capital allowances on the
equipment are not yet reflected. The following additional data also apply to the project. All cash flows
are assumed to occur at the end of the year.
(1) Selling prices, working capital and cost of materials increase with inflation by 5% each year over
the prior year.
(2) Labour costs and overhead expenses (assumed all incremental cash flow) increase by 15% each
year over the prior year.
(3) For tax purposes, capital allowances will be available against the taxable profits of the project, at
25% a year on a reducing balance basis. The first claim will start at year 0. Cash flow from tax
savings will materialise in the following year after allowances are claimed. Any unclaimed
allowance at the end of 5 years will be deductible for tax purposes.
(4) The corporate tax rate is 30%, and payment is due one year in arrears.
(5) The equipment will have a zero salvage value at the end of the project’s life.
(6) The company’s real after-tax weighted average cost of capital is estimated to be 15%, and its
nominal after-tax weighted average cost of capital is 20%. Project risk is assumed to be the same
as the overall risk of the company.
Required:
Take the effect of inflation each year into consideration and show calculations.
(a) What are the taxable cash flows from year 1 to year 5?
(2 marks)
(b) How much tax is saved for each of the six years (year 1 to year 6) due to capital
allowances? Show the amount and timing of tax savings realised.
(3 marks)
(c) What are the changes in working capital requirements for each year from year 0 to year 5?
(3 marks)
(d) Based on Net Present Value (NPV) analysis, should Company P invest? State the reason
for your recommendation. In addition to NPV, what other factors should Company P
consider before making a final decision?
(11 marks)
Recommended Solution
(a) Taxable Cash Flows
Year 1 2 3 4 5
$000 $000 $000 $000 $000
Sales Revenue (5% Inflation) 3,544 4,465 5,470 5,743 5,169
Payments:
Materials (5% Inflation) (709) (893) (1,094) (1,149) (1,034)
Labour (15% Inflation) (1,164) (1,607) (2,258) (2,597) (2,715)
Overheads (15% Inflation) (466) (625) (719) (826) (950)
TAXABLE CASH FLOWS 1,205 1,340 1,399 1,171 469
Interest expense is not included in the above, since the costs of debt and associated interest
expenses are already included in the cost of capital discount rate.
Straight-line accounting depreciation has also been ignored as tax-allowable depreciation (capital
allowances) is available on a reducing balance basis (not straight-line!).
(b)
Tax Saved from Capital Allowances (CA) / Tax Allowable Depreciation (TAD) in $’000’s
Year Balance Tax Savings at 30% Timing
0 Initial investment (2,700)
C.A. @ 25% 675 203 Yr 1
(2,025)
1 C.A. @ 25% 506 152 Yr 2
(1,519)
2 C.A. @ 25% 380 114 Yr 3
(1,139)
3 C.A. @ 25% 285 85 Yr 4
(854)
4 C.A. @ 25% 214 64 Yr 5
(641)
5 Balancing allowance 641 192 Yr 6
Disposal value zero
0
(c)
Working Capital Requirements in $’000’s
Year 0 1 2 3 4 5
Real Working capital required 270 338 405 473 473 405
5% Inflated Working capital required 270 354 447 547 574 517
Incremental cash flow (change) in
working capital requirements (270) (84) (92) (100) (27) 57
Working capital released in year 5 517
Total working capital cash flows (270) (84) (92) (100) (27) 574
Year 0 1 2 3 4 5 6
$000 $000 $000 $000 $000 $000 $000
Taxable Cash Flows from (a) 1,205 1,340 1,399 1,171 469
Tax Payments @ 30% (361) (402) (420) (351) (141)
Tax Savings from CA (b) 203 152 114 85 64 192
Initial Investment (2,700)
Working Capital from (c) (270) (84) (92) (100) (27) 574
Reccomendation: The investment should be accepted as the above finanical analysis shows a
positive NPV of $150,000
The reason for accepting this investment is it has a positive NPV and this will increase the wealth of
the company and shareholders by $150,000.
The project should support Company P’s long-term strategic plans, for example helping to support
the company’s competitive strategies such as cost leadership, differentiation and focus strategies.
Since the new machine raises the Company P’s revenue this should as increase market share and
support the companies growth strategies such as developing new markets or new products.
Forecasting future cash flows is always difficult and subject to risk and estimation errors in the NPV
calculation especially when the NPV calculated is a small $150,000 value as above.
Risks and small errors could make this positive NPV become an unattractive negative NPV project,
and so I would recommend Company P further investigates this investment using sensitivity
analysis.
Finally, before making a final decision Company P should consider if there are any other alternative
investment projects that may offer a better return than this project.
Examiner comments:
Only a few candidates addressed this question well by indicating the other qualitative factors to be
considered for a capital budgeting questions. It was noticed that some candidates did not elaborate in
enough detail corresponding to the significant number of marks awarded for this part of the question,
indicating either that they did not have enough preparation or simply a matter of bad examination
technique. Another observation, again related to examination technique, is that a number of
candidates simply lumped their answers for a to d together, i.e., without identifying the
answers corresponding to the question breakdown. This ran the risk of losing marks for the
whole question.
There are two methods for calculating the NPV of foreign projects:
METHOD 1 – ANNUAL INFLATIONARY EFFECTS ON EXCHANGE RATES (RECOMMENDED)
1. Estimate the projects cash flows in the foreign currency using a taxable profits approach
2. Convert the foreign cash flows into the home currency using PPPT forecast exchange rates
3. Deduct any home country tax payments
4. Discount the net home country cash flows using a country risk adjusted cost of capital
(WACC) to arrive at NPV
Both methods will give you the same NPV, but method 1 is the preferred method (shown below)
when dealing with exchange rate movements between the countries:
Year 0 1 2 3 4 5
FC FC FC FC FC FC
Sales Revenue X X X X
Payments:
Wages (X) (X) (X) (X)
Materials (X) (X) (X) (X)
Less Tax Allowable Depreciation / CA (X) (X) (X) (X)
TAXABLE PROFITS X X X X
Foreign Tax @ say 15%: Delay 1 year? (X) (X) (X) (X)
HK Tax on foreign taxable profits @1.5%: Delay 1 year? (X) (X) (X) (X)
TAXATION
Simple rule: If the HK tax rate is higher, the difference in rates is the additional HK tax rate on
foreign taxable profits.
The country risk premium refers is the difference between the higher interest rates that less stable
and riskier countries must pay to attract investors, and the interest rates of the investor’s home
country (Hong Kong).
Macroeconomic factors such as political and economic instability, regulatory and legal
environment causes investors to be wary of foreign investment opportunities, so they will require a
higher premium (higher return) for investing.
The country risk premium will be higher for developing countries than for developed countries.
If the project requires investing in a risky foreign country an additional country risk premium should
be added to the discount rate to account for the added additional country risk.
The country risk premium should be added into the CAPM formulae (shown below) by adjusting
the cost of equity:
Ke = rf + βe x (rm-rf + country risk premium)
However, in June 2016 the examiner made this adjustment by simply adding the country risk premium
to the existing companies cost of capital (WACC) to get a nearest approximation, since no detailed
cost of equity CAPM information was available in the question.
You are the Chief Financial Officer (“CFO”) of TTC, a company listed on the Hong Kong Stock
Exchange. The functional currency is Hong Kong dollars. The company is considering expanding its
market to Brazil where the currency is BRL (Brazilian Real). Initial investment is BRL50 million and the
project life is 4 years. Except for the overseas nature, other aspects of this project are consistent with
the overall business activities of the company.
(1) Current unit selling price is BRL15.0. Expected inflation is 5% per year.
(2) Current unit variable cost is BRL6.0. Expected inflation is 4% per year.
(3) Starting from next year (year 1), fixed cost is BRL4.5 million per year, which includes an
annual amortisation charge of BRL2 million due from an intangible asset relevant to this
project. Expected inflation for fixed cost is 6% per year.
(4) Investment is to be financed by a bank loan at a fixed interest of 10%.
(5) Company can claim 25% reducing balance tax depreciation. Deduction starts from year 1.
(6) Company pays tax one year in arrears at 30%.
(7) Project has no salvage value.
(8) Real weighted average cost of capital is 9% per year, expected general inflation in Hong Kong
and Brazil is 4.3% per year.
(9) Country risk premium for Brazil is 5%.
(10) Assume the company has enough tax losses from other sources to take advantage of all
benefits resulting from the capital allowance deduction.
(11) Expected unit sales:
Required:
(a) Should the company take the project? Provide justification and calculations.
(13 marks)
(b) Explain your rationale based on the discount rate used in part (a).
(4 marks)
(c) Explain how the company can incorporate the foreign exchange risk into the analysis.
(2 marks)
Recommended solution
(a)
Year 0 1 2 3 4 5
BRL BRL BRL BRL BRL BRL
000’s 000’s 000’s 000’s 000’s 000’s
Sales Revenue (5% Inflation) 39,375 74,430 95,535 45,600
Payments:
Variable costs (4% Inflation) (15,600) (29,205) (37,125) (17,550)
Relevant Fixed costs (6% Inflation) (2,500) (2,650) (2,809) (2,978)
Less Tax Allowable Depreciation / CA (W1) (12,500) (9,375) (7,031) (21,094)
TAXABLE PROFITS 8,775 33,200 48,570 3,978
Foreign Tax @ 30% (2,633) (9,960) (14,571) (1,193)
Discount factors @ 18.69% (W2) 1.000 0.843 0.710 0.598 0.504 0.425
HK$ Present value (X) X X X X (X)
However, in this question we cannot calculate the HK$ NPV as no exchange rates where provided, so
instead we only need to calculate the BRL NPV, shown below:
Net Foreign Cash Flows (50,000) 21,275 39,942 45,641 10,501 (1,193)
x x x x x x
Discount factors @ 18.69% (W2) 1.000 0.843 0.710 0.598 0.504 0.425
BRL Present value (50,000) 17,925 28,353 27,297 5,291 (507)
Reccomendation: The project should be accepted as the above finanical analysis shows a
positive NPV of BRL28,359,000
Relevant Fixed costs have been calculated by excluding the annual BRL2 million amortisation charge,
since this is a non-cash flow accounting adjustment.
WORKINGS
(b)
As the project involves specific inflation rates affecting the individual foreign cash flows such as
sales inflation of 5%, variable costs of 4% and fixed costs of 6%, a nominal (money approach) must be
taken by inflating up individual cash flows using specific inflation rates.
The real discount rate (real WACC) is then inflated up using HK’s general inflation rate because HK
investors in the project would be interested in their ability to buy a basket of general HK goods and not
any one particular good from the project returns.
As the project is in a risky foreign overseas country the discount rate must be increased by the
country risk premium to reflect the increased return investors will demand due to the additional
foreign project risk.
The country risk premium is normally added into the Cost of Equity (Ke) CAPM formulae, but since
this information is not available, to get a best approximation it has been added in to the weighted
average cost of capital (WACC) instead.
(c)
There are two methods that can be used to incorporate foreign exchange risk:
The preferred method is to convert all BRL cash flows into HK$ by estimating and applying exchange
rates for each year using Purchasing Power Parity Theory (PPPT) before calculating the HK$ NPV
using the above country risk adjusted WACC of 18.69%.
The second method would involve adjusting each annual discount rate (WACC) to an overseas
equivalent using future annual general inflation differentials between the two countries, then after
discounting, converting the BRL NPV into HK$’s using todays current spot exchange rate.
Both approach’s use inflation to estimate the effects on future exchange rate movements (risk) and
would give the same HK$ Net Present Value.