Copyright First Intuition
Chapter 7: Capital structure
185 DH has 5 million $2 shares in issue currently trading at $4.00. It also has $4 million 10%
irredeemable debenture stock currently trading at $125 per $1. The post-tax cost of debt has been calculated as 7.5% and the cost of equity at 10.5%.
Calculate the weighted average cost of capital of DH to the nearest 0.1%.
%
186 NQ has 5 million $1 shares in issue currently trading at $3.60 cum div. NQ is about to pay a dividend of $0.40 a share and aims to pay a constant dividend each year. It also has $10 million 7% irredeemable debenture stock currently trading at par. The post-tax cost of debt has been calculated as 4.9%.
Calculate the weighted average cost of capital of NQ to the nearest 0.1%.
%
187 The statement of financial position of RT shows that its financing mix consists of 15% ordinary shares, 50% reserves and 35% debt capital. Ordinary shares consist of 7.5 million $1 shares trading at $3.50 per share and debt capital consists of 17.5 million bonds trading at $150 per
$100 nominal. The cost of the equity capital is 14% and the cost of the debt capital is 9%.
Which is the best method of calculating the weighted average cost of capital?
(30% × 14%) + (70% × 9%)
(50% × 14%) + (50% × 9%)
(65% × 14%) + (35% × 9%)
(66% × 14%) + (34% × 9%)
188 The traditional theory of gearing states that, as gearing increases, a company's weighted average cost of capital:
Rises initially then falls
Remains constant
Falls consistently
Falls initially then rises
189 If the financial gearing of a company increases, then
The required return on equity increases.
The required return on debt decreases.
The level of dividend decreases.
Market interest rates increase.
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190 A company has a cost of debt of 5%, a weighted average cost of capital of 8% and a debt: equity ratio of 1:2. What is its cost of equity?
3%
7%
9.5%
14%
191 BL is deciding whether to raise debt or equity to finance a new investment. Which of the following factors is least likely to persuade the company to choose debt?
Gearing is low.
Interest rates are falling.
BL is expected to make a profit in the next year.
BL has aimed to increase dividends by 5% per annum over the last few years.
192 Under traditional theory, a company’s target capital structure is consistent with:
Minimum cost of debt
Minimum cost of equity
Minimum weighted average cost of capital
Minimum payments to finance providers
193 Does an entity’s capital structure affect or not affect the following?
Affect Not affect
Return on capital employed
Default risk
194 Which of the following factors might cause a company to increase the proportion of debt in its capital structure?
A fall in the corporate tax rate
An increase in economic uncertainty
A fall in the base rate of interest
A fall in the market value of its shares
195 Which of the following is not an assumption of Modigliani and Miller’s 1963 gearing theory?
The capital market is strongly efficient.
Debt is risk-free.
The cost of debt varies according to the level of gearing.
Investors and companies can borrow at the same rate of interest.
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196 Do the Modigliani and Miller (1963) and traditional theories of capital structure conclude that there is an optimum capital structure at which the weighted average cost of capital is minimised and company value is maximised?
Optimum
level No optimum
level
Traditional
Modigliani and Miller
197 According to Modigliani and Miller, the cost of equity will always rise with greater gearing because:
Interest cover is greater.
The returns to shareholders become more variable.
The tax shield on debt increases the value of equity.
The cost of debt will be falling.
198 EF has identical operating and risk characteristics to GH, but their capital structures differ. EF has 20 million $1 shares, total value $80 million. GH has 10 million shares and $45 million debt.
The tax rate is 30%.
What is the value per share of GH’s equity, to the nearest $0.01?
$
199 TD and LP are identic al companies except that TD is financed entirely by equity and LP has a 1:1 debt:equity ratio. TD’s cost of equity is 16% and LP’s pre-tax cost of debt is 9%. Tax is payable at 30%.
What is LP’s cost of equity to the nearest 0.01%?
%
200 PD and SJ are identical companies except that PD is financed entirely by equity and SJ has a 2.25:1 equity:debt ratio. SJ’s cost of equity is 18% and its pre-tax cost of debt is 6%. Tax is payable at 25%.
What is PD’s cost of equity to the nearest 0.01%?
%
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201 Complete the sentence below by placing one of the following options in each of the spaces.
Keeps rising Keeps falling Eventually rises Eventually falls Falls then rises Rises then falls Stays the same
Under the traditional view of gearing, increasing gearing will mean that the cost of equity , the cost of debt
, the weighted average cost of capital and the value of the company .
202 WC has a gearing ratio of 40% (based on market values and measured as debt/debt + equity) and a weighted average cost of capital of 11%. The tax rate is 25%.
Calculate to the nearest 0.01%, using Modigliani and Miller’s theory with tax, the theoretical WACC for WC if its gearing changes to 70%.
%
Use the following information to answer the next two questions.
DD is currently financed solely by equity. Its shares have a market value of $40 million. DD’s cost of capital is 14% and the corporate tax rate is 25%.
DD plans to replace $16 million of equity with 8% irredeemable debt.
203 What will be DD’s new value in $m?
$ m
204 What will be DD’s new weighted average cost of capital, to the nearest 0.01%?
%
205 FX is an all-equity financed company with a cost of capital of 17%. Its directors wish to issue debt and reduce its cost of capital to 15%. The tax rate is 20%.
If the cost of capital fell to 15%, what would be the gearing ratio (debt/debt + equity, using market values) to the nearest 0.01%?
%
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206 DP currently has 10m equity shares with a market value of $25 million and a 10% $15million bank loan. Its directors wish to issue more shares to pay off the bank loan but are unsure of the impact that this will have. DP’s cost of equity is currently 15% and the tax rate is 25%.
Calculate the new cost of capital to the nearest 0.1% if the bank loan is paid off by the share issue.
%
207 FC currently has a gearing ratio of 30% (based on market values and measured as debt/debt + equity) and a weighted average cost of capital of 10.8%. The tax rate is 25%.
Calculate to the nearest 0.01%, using Modigliani and Miller’s theory with tax, the relative percentage change in the weighted average cost of capital if gearing was to increase to 50%
%
208 Using the traditional model of capital structure theory, GK’s weighted average cost of capital is at its lowest when gearing = 35%.
Match the following levels of gearing to their descriptions.
A 20%
209 Which of the following statements in relation to Modigliani and Miller’s 1963 with tax hypothesis are true? Select ALL that apply.
The rate of interest at which investors and companies borrow is irrelevant.
Capital structure influences the weighted average cost of capital and the value of the entity.
Investors are indifferent between personal and corporate gearing.
Tax relief on debt causes the weighted average cost of capital to fall initially and then rise as gearing increases.
210 Which of a company’s sources of capital normally has the highest cost?
Preference shares
Ordinary shares
Bonds
Mezzanine debt
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211 YS is currently all equity-financed and its cost of capital is 12%. It is planning to issue
irredeemable bonds with a coupon rate of 6% and have a debt:equity ratio of 1:2. The tax rate is 25%.
What will be YS’s weighted average cost of capital, to the nearest 0.01%?
%
212 WY has equity with market value of $1,200 million and debt with market value of $600 million.
WY plans to issue $250 million of new shares and use the proceeds to pay off part of the debt.
WY’s current cost of equity is 16% and XZ (an equivalent ungeared company operating in the same business sector) has a cost of equity of 15%. WY’s current weighted average cost of capital is 14% and the tax rate is 25%.
According to Modigliani and Miller’s theory with tax, if the new share capital was issued and the debt was paid off, WY’s weighted average cost of capital would move to:
13.32% = 14% [1 – ( 0.25 ×3501,800 )]
15.03% = 16% [1 – ( 0.25 ×3501,450 )]
14.27% = 15% [1 – ( 0.25 ×3501,800 )]
14.09% = 15% [1 – ( 0.25 ×3501,450 )]
213 YW is an ungeared company with a cost of capital of 12%. It is planning to issue 7% bonds with a yield of 8%, so that its debt:equity ratio will be 1:3. The tax rate is 30%.
According to Modigliani and Miller’s theory with tax, YW’s cost of equity will become:
13.67% = 12% + [(12% - 7%)( 13)]
13.17% = 12% + [(12% - 7%)( 0.73)]
13.33% = 12% + [(12% - 8%)( 13)]
12.93% = 12% + [(12% - 8%)( 0.73)]
214 Modigliani and Miller’s 1963 theory of capital structure with tax assumes that:
The cost of debt is zero.
The cost of equity will rise as gearing increases.
Financial distress costs will mean that the weighted average cost of capital will eventually rise.
Investors are indifferent between dividends and capital gains.
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215 LM has a geared cost of equity of 12% , an ungeared cost of equity of 11.53% and a WACC of 10.95%. The market value of equity is $200 million and the market value of debt is $50 million.
The tax rate is 25%.
LM plans to redeem $25m of debt by a new share issue.
According to Modigliani and Miller’s theory with tax, WACC would move to:
11.10% = 12% [1 – ( 18.75250 )]
11.70% = 12% [1 – ( 6.25250 )]
10.67% = 11.53% [1 – ( 18.75250 )]
11.24% = 11.53% [1 – ( 6.25250 )]
216 KL operates in a no-tax country with the following structure:
Annual payments to investors Market value
$m $m
Equity Dividends 64 400
Debt Interest 12 100
76 500
KL plans to change its debt: equity ratio to 1:7 by the redemption of debt by the issue of new shares. As a result the cost of equity will fall by 2%. The cost of debt will remain unchanged.
Assuming the traditional view of gearing is correct, what will be the new market value to the nearest $m of KL, if gearing is changed as planned?
$ m
217 LO is an ungeared company with a cost of equity of 11%. KT is identical in all respects to LO except that it is financed 75% by equity and 25% by debt using market values. The tax rate is 20%.
According to Modigliani and Miller, what will be the weighted average cost of capital of the geared company, to the nearest 0.01%?
%
218 JC makes an annual profit before interest of $8 million. Its weighted average cost of capital is 16%. JC has a total market valuation of $50 million, 80% of which is equity and $10 million of which is 7% bonds, valued at par. JC proposes to redeem $5 million of bonds by issuing additional share capital.
Assuming Modigliani and Miller’s net operating income view of capital structure is correct, what will be the cost of equity after the reorganisation to the nearest 0.01%? Assume no tax.
%
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219 LB is a ungeared company with a cost of capital of 9%. The risk-free cost of debt is 4% and the tax rate is 20%.
According to Modigliani and Miller, what would be the cost of equity to the nearest 0.01% in a similar geared company that was 70% equity financed and 30% debt financed?
%
220 LR is financed by a combination of equity valued at $150 million and debt capital at $40 million.
The tax rate is 30%.
According to Modigliani and Miller, what would be the market value of an ungeared company that was identical in all other respects to LR?
$ m
221 NS is an ungeared company that has a market capitalisation of $80 million and a cost of capital of 10%. It plans to raise $20 million of fixed rate debt at 5%. The business risk profile of NS will remain unchanged and tax can be ignored.
According to Modigliani and Miller’s theory, what would the new cost of equity be to the nearest 0.01%?
%
222 KT has 100 million $0.50 shares in issue, with a market price of $2.40 per share. It has 50 million 9% irredeemable debt in issue, with a current market value of 108 per cent. The cost of equity is 12% and the tax rate is 25%.
Calculate KT’s weighted average cost of capital, to the nearest 0.01%.
%
223 BW is currently financed by $50 million of equity and $30 million of debt. It has a cost of equity of 12% and a pre-tax cost of debt of 6%. The tax rate is 25%.
Calculate the cost of equity to the nearest 0.1% if BW changes its debt:equity ratio to 40%.
%
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Use the following information to answer the next two questions.
The following information is taken from the most recent accounts of KS.
Statement of financial position
Non-current assets $m 33
Current assets 18
Total assets 51
Equity and liabilities
Share capital 7
Irredeemable preferred shares 2
Reserves 19
Long-term 8% bank loan 12
Trade payables 8
Bank overdraft 3
Total equity and liabilities 51
Statement of profit or loss
Operating profit 3.1
Finance costs 0.7
Profit before tax 2.4
Tax at 25% 0.6
Profit after tax 1.8
KS is planning to raise $4 million additional debt finance at 11%. Operating profit is expected to remain constant. Indications are that KS’s bank intends to renew its overdraft facility for the indefinite future.
224 Calculate the interest cover if the new finance is raised to 2 decimal places.
225 Calculate the gearing level if the new finance is raised to the nearest 0.01%, measuring gearing as (debt/debt + equity) and using book values.
%
226 SA has a debt/equity ratio of 1 to 3 and equity beta of 0.7. Risk free debt has a pre-tax cost of 4% per annum. The expected return on the market portfolio is 9% and tax is 25%.
What is SA’s geared cost of equity to the nearest 0.1%?
%
227 The Finance Director of KH, an unlisted company, is trying to derive its cost of equity. A similar listed company in the same sector has an equity beta of 1.35 and a debt:equity ratio of 40:60.
KH’s debt:equity ratio is 20:80.
The expected return on the market portfolio is 9% and the current return on a risk-free asset is 3%. The tax rate is 25%. Debt can be assumed to be risk-free.
Calculate KH’s cost of equity to the nearest 0.1%.
%
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228 TR’s directors are currently considering replacing all the company’s debt with equity and want to know what the new cost of capital will be. TR currently has a debt-equity ratio of 25:75 and an equity beta of 1.6. The current return on a risk-free investment is 3% and the market risk premium is 7%. The tax rate is 20%.
Calculate TR’s ungeared cost of equity to the nearest 0.1%.
%
229 YT is looking at a potential acquisition, KS, which is an unlisted company. KS has a debt/equity ratio of 25:75.YT needs to identify an appropriate cost of capital to be used in this calculation and therefore it needs to identify a suitable equity beta for KS.
The following information is available about three companies that have similar business risk to KS, but different capital structures.
Debt/equity
ratio Equity beta
XP 30:70 1.6
ZW 15:85 1.3
QL 45:55 2.0
Which of the following is likely to be the best estimate of KS’s equity beta?
1.0
1.25
1.5
1.75
230 JM is looking to diversify and is considering the acquisition of UN, a company in a different market sector. JM needs to calculate the cost of equity of UN as part of a valuation exercise. JM has a debt:equity ratio of 20:80 and UN has a debt:equity ratio of 25:75.
JM has obtained information about a similar company to UN in the same business sector.
This company has a debt:equity ratio of 40:60 and an equity beta of 1.7.
The current return on a risk-free investment is 2% and the return on the market portfolio is 9%.
The tax rate is 30% and debt is assumed to be risk-free.
Calculate, to the nearest 0.1%, the cost of equity that should be used as part of the valuation of UN.
%
231 The directors of MK are about to undertake a new investment and need to carry out an investment appraisal. They have decided to use the Adjusted Present Value approach and therefore need to calculate an ungeared cost of equity. MK has a debt/equity ratio of 40% and an equity beta of 1.2. The return on risk-free assets is 5% and the expected return on the market portfolio is 10%. The tax rate is 25%.
Calculate, to the nearest 0.1%, the cost of equity that should be used as part of the adjusted present value calculation.
%
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232 The directors of PN are currently considering raising debt finance to fund a new investment.
PN is currently an all-equity financed company with a Beta factor of 1.05. Taking on the debt finance will result in a debt-equity ratio of 25:75. Debt can be assumed to be risk-free and have a pre-tax cost of 4%. The return on the market portfolio is 12% and the tax rate is 30%.
Calculate, to the nearest 0.1%, PN’s cost of equity if it uses the debt to fund the investment.
%
233 LL has a debt:equity ratio of 35% and an asset beta of 1.3. Debt has a beta of 0.2. The return on the market portfolio is 11% and the return on a risk-free investment is 5%. The tax rate is 25%.
Calculate, to the nearest 0.1%, LL’s geared cost of equity.
%
234 JN is an unlisted company with a debt/equity ratio of 30:70. JN’s Finance Director wishes to calculate its geared cost of equity, using a proxy listed company, XR, in the same industry. XR’s debt:equity ratio is 45:55 and its equity beta is 1.85. The tax rate is 30% and the beta of debt is 0.15.
Which of the following shows the correct formula for regearing XR’s asset beta and hence obtaining an equity beta for JN?
βg = 1.18 + (1.18 – 0.15) 45 (1−0.3)55
βg = 1.23 + (1.23 – 0.15) 45 (1−0.3)55
βg = 1.18 + (1.18 – 0.15) 30 (1−0.3)70
βg = 1.23 + (1.23 – 0.15) 30 (1−0.3)70
235 The directors of ZX are considering whether to acquire BQ, an unlisted company. They are looking to value BQ by discounting its future earnings and hence need to compute its weighted average cost of capital.
BQ currently has a debt:equity ratio of 22:78. Its debt can be assumed to be risk-free and have a pre-tax cost of 4%.
A similar quoted company to BQ has an equity beta of 1.4 and a debt:equity ratio of 35:65.
The expected return on the market portfolio is 11% and the tax rate is 25%.
Calculate, to the nearest 0.1%, the weighted average cost of capital of BQ.
%