Capital Structure Theories

The following scenario relates to Q46-50.
A meeting was conducted by the board of directors of Brocade Co to discuss the balance of equity & debt financing. The following statements were made by the directors:

Director A: We should keep our weighted average cost of capital at the lowest by keeping the optimum balance of gearing.
Director B: The Company is placed in a perfect market & no need to consider the balance of equity & debt.
Director C: We should finance the whole operations using only debt sources of finance to gain tax reliefs.
Director D: We should choose debt or equity sources of financing only if retained profits are insufficient or unavailable.

Q46. Which director seems to support Pecking order theory? (MCQ)

Director A
Director B
Director C
Director D
(2 marks)

Q47. Director A’s statement is applying which theory? (MCQ)

Traditional Theory
M;M Theory 1958
Pecking Order Theory
M;M Theory 1963 tax
(2 marks)

Q48. Which of the following directors seems to have a risk of tax exhaustion? (MCQ)

Director A
Director B
Director C
Director D
(2 marks)

Q49. Which of the following director thinks to offset the increased cost of equity with benefit gained on debt? (MCQ)

Director A
Director B
Director C
Director D
(2 marks)

Q50. Which of the following statements is incorrect? (MCQ)

Equity financing is costly as compared to loans
A bank is at low risk as they are secured by mortgages
Cost of capital is decreased if the market value of the company rises
The company receives no tax benefits
(2 marks)

WACC (BASIC) ; RISK ADJUSTED WACC
The following scenario relates to Q51-55.
Fasces’ Co is a listed company. It is wholly financed using equity & its shares are bought by financial intermediaries. Recently, a finance director was replaced as the previous director was relocated to another country. The new director wants to apply capital asset pricing model to assess risk & include stock market reactions. The finance director has done some research which is as follows:
The Risk-free return 3% per annum
The Return of government securities 12% per annum
Hearses Co (Competitor) 0.8 Equity Beta
Q51. Calculate the return on equity of Hearses Co? (MCQ)

3%
9.6%
10.2%
32%
(2 marks)

Q52. The annual return on equity is assumed to be 22%. Calculate the equity beta of Fasces’ Co? (MCQ)

2.1%
3.7%
17.6%
22%
(2 marks)

Q53. Which of the following statements are true? (MRQ)

The beta of Fasces’ Co is indicating an unsystematic risk
Fasces’ Co will like to obtain a return greater than the government securities
The return obtained will be determined using unsystematic risk
If Fasces’ Co share price increases, then equity beta will also increase
(2 marks)

Q54. Fasces’ Co paid an interim dividend of 35c/share. The share price increase by 20% to $5.4/share. What is the total shareholder return (to the nearest %)? (FIB)
596901651000%
(2 marks)
Q55. Fasces’ Co is a garment business. Which of the following circumstances will the company use its own WACC? (MCQ)

Buying its competitor’s business
Buying a shoe manufacturer
Buying a retailer shop
Buying a supermarket
(2 marks)

The following scenario relates to Q56-60.
Gruber Co is stock exchange listed company has issued 100 million shares in the market. The current share price is $2.65/share. Gruber Co also issued bonds having a book value of $60 million. The current market price is $104/$100 bonds. The cost of debt for the company is 9% with paying a corporation tax of 30%. The dividends have been paid as follows:
Year 2010 2011 2012 2013 2014
DPS ($) 0.19 0.2 0.25 0.3 0.32
Q56. Calculate the cost of equity of Gruber Co? (MCQ)

13.9%
15.4%
27.6%
29.1%
(2 marks)

Q57. Calculate the WACC? (MCQ)

9%
11%
17.9%
24%
(2 marks)

Q58. The company is issuing bonds worth $40 million at par. These would pay an interest before tax of 8% ; will be redeemed at 5 % premium after ten years. Calculate the cost of debt? (MCQ)

5%
6.17%
10.45%
11%
(2 marks)

Q59. The market value of equity is $250 ; the cost is 13%. The cost of debt is 9% ; the market value is $50. Calculate the WACC including the information of Q58? (MCQ)

8.2%
10.9%
11.6%
12.3%
(2 marks)

Q60. Which of the following factors would likely affect the market value of a bond? (MRQ)

The frequency of interest payments
The redemption value of the bond
The time duration of repayment
The amount of interest repayable
(2 marks)

The following scenario relates to Q61-65.
Nastic Co has in issue ten million ordinary shares each having a current market value of $7.5. The company has 7% bonds at par value. The bonds are redeemable in seven years at par. The bonds are currently trading at $112/bond. The total nominal value sits at $14,000,000. Nastic Co equity beta is 0.7. The risk-free rate is 5% per annum ; average return in the market is 13% per annum.
Nastic Co wants to diversify his business opportunities ; are thinking to invest in the same industry. A potential company has been seen bidding for Bracey Co. Its equity to debt ratio in the market is 75% to 25%. The equity beta is 1.6.
Both companies are subject to pay a corporation tax of 20%
Q61. Calculate the cost of debt? (MCQ)

3.29%
4.27%
9.1%
10.3%
(2 marks)

Q62. Cost of the equity of 11% is assumed. What will be the weighted cost of capital? (MCQ)

3.8%
5.21%
8.24%
9.7%
(2 marks)

Q63. Calculate the risk-adjusted beta? (MCQ)

1.2 Beta
1.37 Beta
1.74 Beta
2.1 Beta
(2 marks)

Q64. Calculate the risk-adjusted cost of equity? (FIB)

596901968500%
(2 marks)

Q65. Which of the following is not a disadvantage of CAPM? (MCQ)

Differentiation in capital gains ; dividends are ignored
The return of the market is incorporated
It assumes that all shareholders are diversified
Beta factors might be inaccurate
(2 marks)

ANSWERS

Q46. D
Q47. A
Q48. C
Q49. B
Q50. D

The company receives a tax benefit on their interest payments.
Q51. C

Use CAPM formulae
Ke = 3 + (12 – 3) 0.8 = 10.2%

Q52. A

Use CAPM formulae
Ke = 3 + (12 – 3) X = 22
X = 2.1%

Q53.

The beta of Fasces’ Co is indicating an unsystematic risk (False)
Fasces’ Co will like to obtain a return greater than the government securities (True)
The return obtained will be determined using unsystematic risk (False)
If Fasces’ Co share price increases, then equity beta will also increase (True)
The equity beta measures the changes in the return of share price. The return will be determined by using systematic risk as unsystematic risk is diversifiable.

Q54. 28%

Total shareholder return = [(5.4 – 4.5) + 0.35] ÷ 4.5 =0.2777
0.2777 × 100 = 27.7%

Q55. A

An investing company can use its own WACC only when its business risk & financial risk remains same. In the case of buying its competitor, its business risk & financial risk will remain same. All other option will change the business risk and will have to use risk-adjusted WACC.

Q56. C

g = [(0.32 ÷ 0.19) 1 ÷ (5-1) – 1] × 100 = 13.9%
D1 = (0.32 × (1 + 13.9%) = 0.364
Ke = [(0.364 ÷ 2.65) + 13.9%] × 100 = 27.6%

Q57. D

($m) ($m)
Equity 100 × 2.65 265 × 27.6% 73.14
Debt (60 ÷ 100) × 104 62.4 ×9% 5.616
Total 327.4 78.756
WACC = (78.756 ÷ 327.4) × 100 = 24%

Q58. B

Year Cash flow ($) DF (5%) Present value ($) DF (10%) Present Value ($)
MV/Bond 0 (100) 1 (100) 1 (100)
Interest 1-10 5.6 7.72 43.23 6.14 34.38
Redeem 10 105 0.614 64.47 0.386 40.53
NPV 7.7 (25.09)
Redemption= 100 × 105% = 105
IRR = 5 + [7.7 ÷ (7.7 – (-25.09)] × (10 – 5) = 6.17%

Q59. C

($m) ($m)
Equity 250 250 × 13% 32.5
Debt 50 50 × 9% 4.5
Debt (Bonds) (40 ÷ 100) × 100 40 × 6.17% 2.468
Total 340 39.468
WACC = (39.468 ÷ 340) × 100 = 11.6%

Q60. All options are correct.
Q61. A

Year Cash flow ($) DF (5%) Present value ($) DF (10%) Present Value ($)
MV/Bond 0 (112) 1 (112) 1 (112)
Interest 1-7 5.6 5.786 32.4 4.868 27.3
Redeem 7 100 0.711 71.1 0.513 51.3
NPV (8.5) (33.4)
IRR = 5 + [-8.5 ÷ (-8.5 – (-33.4)] × (10 – 5) = 3.29%

Q62. D

($m) ($m)
Equity 10 × 7.5 75 × 11% 8.25
Debt (14 ÷ 100) × 112 15.68 ×3.29% 0.516
Total 90.68 8.766
WACC = (8.766 ÷ 90.68) × 100 = 9.7%

Q63. C

Ba = [75 ÷ (75 + 15.68 × {1-20%})] × 1.6 = 1.37
1.37 = [75 ÷ (75 + 25 × {1-20%})] × BeBe = 1.74

Q64. 18.92%

Ke = 5 + (13-5) × (1.74) = 18.92%

Q65. B