F9 Financial Management

Chapter 16 Capital Structure

SYLLABUS

1. Describe the traditional view of capital structure and its assumptions.

2. Describe the views of M&M on capital structure, both without and with corporate
taxation, and their assumptions.
3. Identify a range of capital market imperfections and describe their impact on the
views of M&M on capital structure.
4. Explain the relevance of pecking order theory to the selection of sources of finance.

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1. Company Value and the Cost of Capital

1.1 The objective of management is to maximize shareholder wealth. If altering the

gearing ratio could increase wealth, then finance managers would have a duty to do so.
1.2 Is it possible to increase shareholder wealth by changing the gearing ratio?
(a) The market value of a company is the sum of the market values of its various
forms of finance. This equates to the market value of the company’s equity
plus dent.
(b) The market value of each type of finance is known to be the present value of
the returns to the investor, discounted at their required rate of return.
(c) If a company distributes all its earnings, if follows that the total market value
of the company equates to the present value of the future cash flows
available to investors, discounted at their overall required return or
WACC.
1.3 The following simplified formula can be used to value a company:

Future cash flows

Market value of a company =
WACC

If you can reduce the WACC, this results in a higher market value or NPV of the
company and therefore an increase in shareholder wealth as they own the company.

2. The Traditional View of Capital Structure

(Pilot, Jun 09, Jun 11, Dec 13, Jun 15)
2.1 Traditional view
Under the traditional theory of cost of capital, the cost declines initially and then
rises as gearing increases. The optimal capital structure will be the point at which
WACC is lowest.

2.2 The traditional view of capital structure is that there is an optimal capital structure
and the company can increase its total value by suitable use of debt finance in its
capital structure.

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2.3 Assumptions
The assumptions on which this theory is based are as follows:
(a) The company pays out all its earnings as dividends.
(b) The gearing of the company can be changed immediately by issuing debt
to repurchase shares, or by issuing shares to repurchase debt. There are no
transaction costs for issues.
(c) The earnings of the company are expected to remain constant in
perpetuity and all investors share the same expectations about these future
earnings.
(d) Business risk is also constant, regardless of how the company invests its
funds.
(e) Taxation, for the timing being, is ignored.

2.4 The traditional view is as follows:

(a) As the level of gearing increases, the cost of debt remains unchanged up to a
certain level of gearing. Beyond this level, the cost of debt will increase.
(b) The cost of equity rises as the level of gearing increases and financial risk
increases. There is a non-linear relationship between the cost of equity and
gearing.
(c) The WACC does not remain constant, but rather falls initially as the
proportion of debt capital increases, and then begins to increase as the rising
cost of equity (and possibly of debt) becomes more significant.
(d) The optimum level of gearing is where the company’s WACC is minimized.
2.5 The traditional view about the cost of capital is illustrated in the following figure. It
shows that the WACC will be minimized at a particular level of gearing X.

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Where Ke is the cost of equity in the geared company

Kd is the cost of debt
WACC is the weighted average cost of capital

2.6 Conclusion – there is an optimal level of gearing – point X. At point X the overall
return required by investors (debt and equity) is minimised. It follows that at this point
the combined market value of the firm’s debt and equity securities will also be
maximised.
2.7 Company should gear up until it reaches optimal point and then raise a mix of finance
to maintain this level of gearing. However, there is no method, apart from trial and
error, available to locate the optimal point.

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3. The Net Operating Income (Modigliani-Miller (M&M)) View of

WACC (Pilot, Jun 09, Jun 11, Dec 13, Jun 15)

3.1 Principle of M&M I

Modigliani and Miller stated that, in the absence of tax, a company’s capital
structure would have no impact upon its WACC.

3.2 The net operating income approach takes a different view of the effect of gearing on
WACC. In their 1958 theory, M&M proposed that the total market value of a
company, in the absence of tax, will be determined only by two factors:
(a) the total earnings of the company.
(b) the level of operating (business) risk attached to those earnings.
3.3 The total market value would be computed by discounting the total earnings at a rate
that is appropriate to the level of operating risk. This rate would represent the WACC
of the company.
3.4 Thus M&M concluded that the capital structure of a company would have no effect
on its overall value or WACC.

3.5 Assumptions
M&M made various assumptions in arriving at this conclusion, including:
(a) A perfect capital market exists, in which investors have the same
information, upon which they act rationally, to arrive at the same
expectations about future earnings and risks.
(b) There are no tax or transaction costs.
(c) Debt is risk-free and freely available at the same cost to investors and
companies alike.

3.6 Summary
If M&M I theory holds, it implies:
(a) The cost of debt remains unchanged as the level of gearing increases.
(b) The cost of equity rises in such a way as to keep the WACC constant.

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3.7 This would be represented on a graph as shown below.

3.8 Example 1
A company has $5,000 of debt at 10% interest, and earns $5,000 a year before
interest is paid. There are 2,250 issued shares, and the WACC is 20%.

The market value of the company should be as follows:

Earnings $5,000
WACC 0.2
$
Market value of the company ($5,000 ÷ 0.2) 25,000
Less: market value of debt (5,000)
Market value of equity 20,000

The cost of equity is therefore

And the market value per share is

Suppose that the level of gearing is increased by issuing $5,000 more of debt at
10% interest to repurchase 562 shares (at a market value of $8.89 per share) leaving
1,688 shares in issue.

The WACC will, according to the net operating income approach, remain
unchanged at 20%. The market value of the company should still therefore be
$25,000.

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Earnings $5,000
WACC 0.2
$
Market value of the company ($5,000 ÷ 0.2) 25,000
Less: market value of debt (10,000)
Market value of equity 15,000

Annual dividends will now be $5,000 – $1,000 interest = $4,000.

The cost of equity has risen to and the market value per share

is still:

Conclusion:
The level of gearing is a matter of indifference to an investor, because it does not
affect the market value of the company, nor of an individual share. This is because
as the level of gearing rises, so does the cost of equity in such a way as to keep both
the weighted average cost of capital and the market value of the shares constant.
Although, in our example, the dividend per share rises from $2 to $2.37, the
increase in the cost of equity is such that the market value per share remains at
$8.89.

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4. M&M with Tax (M&M II)

(Pilot, Jun 09, Jun 11, Dec 13, Jun 15)
4.1 In 1963, M&M modified their model to reflect the fact that the corporate tax system
gives tax relief on interest payments.
4.2 They admitted that tax relief on interest payments does lower the WACC. The savings
arising from tax relief on debt interest are the tax shield (稅盾). They claimed that the
WACC will continue to fall, up to gearing to 100%.
4.3 This suggests that companies should have a capital structure made up entirely of
debt.

4.4 However, this does not happen in practice due to existence of other market
imperfections (市場的不完善) which undermine the tax advantages of debt finance.

5. Market Imperfections View – Problems of High Gearing

(Jun 15)
5.1 When other market imperfections are considered in addition to the existence of
corporation taxation, the view of M&M II that a company should gear up as much as
possible is no longer true.
5.2 These other market imperfections relate to high levels of gearing, bankruptcy risk
and the costs of financial distress, and they cause the cost of debt and the cost of
equity to increase, so that the WACC increases at high levels of gearing.
5.3 Bankruptcy risk – As gearing increases so does the possibility of bankruptcy. If
shareholders become concerned, this will increase the WACC of the company and
reduce the share price.
5.4 Agency costs: restrictive conditions – In order to safeguard their investments,
lenders/debentures holders often impose restrictive conditions in the loan agreements
that constrain management’s freedom of action, e.g. restrictions:
(a) on the level of dividends
(b) on the level of additional debt that can be raised

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(c) on management from disposing of any major fixed assets without the debenture
holders’ agreement.
5.5 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 (1 – t) simply becomes Kd.
5.6 Borrowing/debt capacity – High levels of gearing are unusual because companies run
out of suitable assets to offer as security against loans. Companies with assets which
have an active second-hand market, and with low levels of depreciation such as
property companies, have a high borrowing capacity.
5.7 Difference risk tolerance levels between shareholders and directors – Business
failure can have a far greater impact on directors than on a well-diversified investor. It
may be argued that directors have a natural tendency to be cautious about borrowing.
5.8 Restrictions in the articles of association may specify limits on the company’s ability
to borrow.
5.9 The cost of borrowing increases as gearing increases.

6. Pecking Order Theory (融資順位理論)

(Jun 09, Jun 11)
6.1 Pecking order theory

6.1.1 Pecking order theory has been developed as an alternative to traditional theory. It
states that firms will prefer retained earnings to any other source of finance, and then
will choose debt, and last of all equity. The order of preference will be:
(a) Retained earnings
(b) Straight debt
(c) Convertible debt
(d) Preference shares
(e) Equity shares
6.1.2 Internally-generated funds – i.e. retained earnings
(a) Already have the funds.
(b) Do not have to spend any time persuading outside investors of the merits of the
project.
(c) No issue costs.
6.1.3 Debt
(a) The degree of questioning and publicity associated with debt is usually
significantly less than that associated with a share issue.
(b) Moderate issue costs.
6.1.4 New issue of equity

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(a) Perception by stock markets that it is a possible sign of problems. Extensive

questioning and publicity associated with a share issue.
(b) Expensive issue costs.

6.2 Asymmetric information

6.2.1 Myers has suggested asymmetric information as an explanation for the heavy reliance
on retentions. This may be a situation where managers, because of their access to more
information about the firm, know that the value of the shares is greater than the current
market value (based on the weak and semi-strong market information).
6.2.2 In the case of a new project, managers' forecasts may be higher and more realistic than
that of the market. If new shares were issued in this situation, there is a possibility that
they would be issued at too low a price, thus transferring wealth from existing
shareholders to new shareholders. In these circumstances there might be a natural
preference for internally-generated funds over new issues. If additional funds are
required over and above internally-generated funds, then debt would be the next
alternative.
6.2.3 If management is averse to making equity issues when in possession of favourable
inside information, market participants might assume that management will be more
likely to favour new issues when they are in possession of unfavourable inside
information which leads to the suggestion that new issues might be regarded as a
signal of bad news! Managers may therefore wish to rely primarily on internally-
generated funds supplemented by borrowing, with issues of new equity as a last resort.
6.2.4 Myers and Majluf (1984) demonstrated that with asymmetric information, equity
issues are interpreted by the market as bad news, since managers are only motivated to
make equity issues when shares are overpriced. Bennett Stewart (1990) puts it
differently: ‘Raising equity conveys doubt. Investors suspect that management is
attempting to shore up the firm’s financial resources for rough times ahead by selling
over-valued shares.’
6.2.5 Asquith and Mullins (1983) empirically observed that announcements of new equity
issues are greeted by sharp declines in stock prices. Thus, equity issues are
comparatively rare among large established companies.

Multiple Choice Questions

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1. Which of the following statements is part of the traditional theory of gearing?

A There must be taxes

B There must exist a minimum WACC
C Cost of debt increases as gearing decreases
D Cost of equity increases as gearing decreases

2. A Co’s gearing is 1:1 Debt:equity. The industry average is 1:5. A Co are looking to
raise finance for investment in a new project and they are wondering whether to raise
debt or equity.

According to the traditional view:

A They should take on debt finance as to do so will save tax.

B They should take on equity finance as their gearing is probably beyond optimal.
C It doesn’t matter as it won’t affect the returns the projects generate.
D More information is needed before a decision can be made.

3. Why do Modigliani-Miller (with tax) assume increased gearing will reduce the
weighted average cost of capital (‘WACC’)?

A Debt is cheaper than equity

B Interest payments are tax deductible
C Reduced levels of expensive equity capital will reduce the WACC
D Financial risk is not pronounced at moderate borrowing levels

4. Consider the following statements concerning capital structure.

According to both the traditional view and the Modigliani and Miller (including taxes)
view of capital structure:

1. the point at which the weighted average cost of capital is minimised provides the
optimal capital structure for a company
2. the weighted average cost of capital is minimised at the maximum level of
gearing

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Which one of the following combinations (true/false) concerning the above statements
is correct?

Statement 1 Statement 2
A True True
B True False
C False True
D False False

5. The Modigliani and Miller (with taxes) proposition concerning capital gearing states
that as the level of capital gearing of a business increases from zero, there will be an
initial increase in the:

1. cost of loan capital

2. weighted average cost of capital
3. value of the business
4. cost of equity capital

Which two of the above statements are correct?

A 1 and 2
B 1 and 4
C 2 and 3
D 3 and 4

6. Three views concerning the effect of loan capital on the capital structure of a business
are:

1. The traditional view.

2. The Modigliani and Miller (without taxes) view.
3. The Modigliani and Miller (with taxes) view.

According to each view, what will be the effect (rise/fall/stay constant) on the cost of
equity when the level of loan capital increases?

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Traditional view Modigliani and Miller Modigliani and Miller

(without taxes) view (with taxes) view
A Rise Rise Rise
B Fall Stay constant Rise
C Rise Stay constant Fall
D Fall Fall Fall

7. The Modigliani and Miller (no taxes) proposition concerning capital gearing states
that, as the level of capital gearing increases from zero:

A the cost of equity capital will remain unchanged

B the weighted average cost of capital will decrease
C the value of the business will remain unchanged
D the cost of loan capital will increase

8. Consider the following statements concerning capital structure:

According to the Modigliani and Miller (ignoring taxes) view of capital structure
1. the market value of a geared business is equal to the market value of a similar,
ungeared (all-equity financed) business.
2. the cost of equity in a geared company is equal to the cost of equity in a similar,
ungeared (all equity financed) business.

Which one of the following combinations (true/false) concerning the above statements
is correct?

Statement 1 Statement 2
A True True
B True False
C False True
D False False

9. Consider the following statements concerning capital structure:

According to Modigliani and Miller (without taxes)

1. The cost of equity in a geared company is equal to the cost of equity in a similar

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ungeared company.
2. The cost of debt will remain the same, irrespective of the level of gearing.

Which one of the following combinations (true/false) relating to the above statements
is correct?

Statement 1 Statement 2
A True True
B True False
C False True
D False False

10. Which of the following statements concerning capital structure theory is correct?

A In the traditional view, there is a linear relationship between the cost of equity
and financial risk
B Modigliani and Miller said that, in the absence of tax, the cost of equity would
remain constant
C Pecking order theory indicates that preference shares are preferred to convertible
debt as a source of finance
D Business risk is assumed to be constant
(ACCA F9 Financial Management Pilot Paper 2014)

11. A company incorporates increasing amounts of debt finance into its capital structure,
while leaving its operating risk unchanged.

Assuming that a perfect capital market exists, with corporation tax (but without
personal tax), which of the following correctly describes the effect on the company’s
costs of capital and total market value?

Cost of equity WACC Total market value

A Increases Unaffected Increases
B Unaffected Decreases Increases
C Increases Decreases Increases
D Decreases Increases Decreases

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12. SD Co increased its gearing and its weighted average cost of capital reduced.

Which of the following theories might explain this?

1 Modigliani-Miller (with tax)

2 The traditional view
3 Pecking order theory
4 Modigliani-Miller (no tax)

A 1, 2 and 3 only
B 1 and 4 only
C 1 and 2 only
D 2 and 4 only

13. Pecking order theory suggests finance should be raised in which order?

A Internal funds, rights issue, debt

B Internal funds, debt, new equity
C Debt, internal funds, new equity
D Rights issue, internal funds, debt

Question 1
Below is a series of graphs. Identify those that reflect:
(a) the traditional view of capital structure
(b) M&M without tax
(c) M&M with tax.

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Question 2
Answer the following questions:
A If a company, in a perfect capital market with no taxes, incorporates increasing
amounts of debt into its capital structure without changing its operating risk, what
will the impact be on its WACC?
B According to M&M why will the cost of equity always rise as the company gears
up?
C In a perfect capital market but with taxes, two companies are identical in all
respects, apart from their levels of gearing. A has only equity finance, B has 50%
debt finance. Which firm would M&M argue was worth more?
D In practice a firm which has exhausted retained earnings, is likely to select what
form of finance next?

7. CAPM and M&M Combined – Geared Betas

(Dec 08, Jun 10, Dec 10, Jun 13, Dec 13, Jun 14, Dec 15)
7.1 Introduction

7.1.1 Geared betas

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When an investment has differing business and finance risks from the existing
business, geared betas may be used to obtain an appropriate required return.

Geared betas are calculated by:

(a) Ungearing industry betas
(b) Converting ungeared betas back into a geared beta that reflects the
company’s own gearing ratio

7.1.2 The gearing of a company will affect the risk of its equity. If a company is geared and
its financial risk is therefore higher than the risk of an all-equity company, then the
β value of the geared company’s equity will be higher than theβ value of a similar
ungeared company’s equity.
7.1.3 The CAPM is consistent with the propositions of M&M. M&M argue that as gearing
rises, the cost of equity rises to compensate shareholders for the extra financial risk of
investing in a geared company. This financial risk is an aspect of systematic risk, and
ought to be reflected in a company’s beta factor.

7.2 Geared betas and ungeared betas

7.2.1 The connection between M&M theory and the CAPM means that it is possible to
establish a mathematical relationship between the β value of an ungeared company and
the β value of a similar, but geared, company. The β value of a geared company will be
higher than the β value of a company identical in every respect except that it is all-
equity financed. This is because of the extra financial risk. The mathematical
relationship between “ungeared” (or asset) and “geared” betas is as follows.

Where is the asset or ungeared beta

is the equity or geared beta
is the beta factor of debt in the geared company
is the market value of the debt capital in the geared company
is the market value of the equity capital in the geared company
T is the rate of corporate tax
7.2.2 Debt is often assumed to be risk-free and its beta is then taken as zero, in which case

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the formula above reduces to the following form.

or, without tax,

7.2.3 Example 2
Two companies are identical in every respect except for their capital structure.
Their market values are in equilibrium, as follows.

Geared Ungeared
$000 $000
Annual profit before interest and tax 1,000 1,000
Less: Interest (4,000 x 8%) 320 0
680 1,000
Less: Tax @30% 204 300
Profit after tax = dividends 476 700

Market value of equity 3,900 6,600

Market value of debt 4,180 0
Total market value of company 8,080 6,600

The total value of Geared is higher than the total value of Ungeared, which is
consistent with M&M.

All profits after tax are paid out as dividends, and so there is no dividend growth.
The beta value of Ungeared has been calculated as 1.0. The debt capital of Geared
can be regarded as risk-free.

Calculate:

(a) The cost of equity in Geared.

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(b) The market return Rm.

(c) The beta value of Geared.

Solution:
(a) Since its market value (MV) is in equilibrium, the cost of equity in Geared
can be calculated as:

(b) The beta value of Ungeared is 1.0, which means that the expected returns
from Ungeared are exactly the same as the market returns, and R m =
700/6,600 = 10.6%

(c)

The beta of Geared, as we would expect, is higher than the beta of Ungeared.

7.3 Using the geared and ungeared beta formula to estimate a beta factor

7.3.1 Another way of estimating a beta factor for a company’s equity is to use data about the
returns of other quoted companies which have similar operating characteristics: that is,
to use the beta values of other companies’ equity to estimate a beta value for the
company under consideration.
7.3.2 The beta values estimated for the firm under consideration must be adjusted to allow
for differences in gearing from the firms whose equity beta values are known. The
formula for geared and ungeared beta values can be applied.
7.3.3 If a company plans to invest in a project which involves diversification into a new
business, the investment will involve a different level of systematic risk from that
applying to the company’s existing business.
7.3.4 A discount rate should be calculated which is specific to the project, and which
takes account of both the project’s systematic risk and the company’s gearing level.
The discount rate can be found using the CAPM.
Step 1 Get an estimate of the systematic risk characteristics of the project’s
operating cash flows by obtaining published beta values for companies in
the industry into which the company is planning to diversify.
Step 2 Adjust these beta values to allow for the company’s capital gearing level.
This adjustment is done in two stages.
(a) Convert the beta values of other companies in the industry to ungeared

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betas, using the formula:

(b) Having obtained an ungeared beta value , convert it back to geared

beta , which reflects the company’s own gearing ratio, using the
formula:

Step 3 Having estimated a project-specific geared beta, use the CAPM to estimate:
(a) A project-specific cost of equity, and
(b) A project-specific cost of capital, based on a weighting of this cost of
equity and the cost of the company’s debt capital.

7.3.5 Example 3
A company’s debt : equity ratio, by market values, is 2 : 5. The corporate debt,
which is assumed to be risk-free, yields 11% before tax. The beta value of the
company’s equity is currently 1.1. The average returns on stock market equity is
16%.

The company is now proposing to invest in a project which would involve

diversification into a new industry, and the following information is available about
this industry.

(a) Average beta coefficient of equity capital = 1.59

(b) Average debt : equity ratio in the industry = 1 : 2 (by market value)

The rate of corporation tax is 30%. What would be a suitable cost of capital to
apply to the project?

Solution:

Step 1 The beta value for the industry is 1.59.

Step 2 (a) Convert the geared beta value for the industry to an ungeared beta
for the industry.

(b) Convert this ungeared industry beta back into a geared beta, which

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reflects the company’s own gearing level of 2 : 5.

Step 3 (a) 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
as:
Keg = 11% + (16% – 11%) × 1.51 = 18.55%
(b) The project will presumably be financed in a gearing ratio of 2 : 5
debt to equity, and so the project-specific cost of capital ought to be:
[5/7 × 18.55%] + [2/7 × 70% × 11%] = 15.45%

7.3.6 Weaknesses in the formula:

(a) It is difficult to identify other firms with identical operating
characteristics.
(b) Estimates of beta values from share price information are not wholly
accurate. They are based on statistical analysis of historical data, and as the
previous example shows, estimates using one firm’s data will differ from
estimates using another firm’s data.
(c) There may be differences in beta values between firms caused by:
(i) Different cost structures (e,g, the ratio of fixed costs to variable costs)
(ii) Size differences between firms
(iii) Debt capital not being risk-free
(d) If the firm for which an equity beta is being estimated has opportunities for
growth that are recognized by investors, and which will affect its equity beta,
estimates of the equity beta based on other firm’s data will be inaccurate,
because the opportunities for growth will not be allowed for.

Multiple Choice Questions

14. Leah Co is an all-equity financed company which wishes to appraise a project in a

new area of business. Its existing equity beta is 1.2. The average equity beta for the
new business area is 2.0, with an average debt/debt plus equity ratio of 25%. The risk-
free rate of return is 5% and the market risk premium is 4%.

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Ignoring taxation and using the capital asset pricing model, what is the risk-adjusted
cost of equity for the new project?

A 8.6%
B 9.8%
C 11.0%
D 13.0%
(ACCA F9 Financial Management December 2015)

15. Shyma Co is a company that manufactures ships and has an equity beta of 1.6 and a
debt-equity ratio of 1:3. It is considering a new project to manufacture farm vehicles.

Trant Co is a manufacturer of farm vehicles and has an asset beta of 1.1 and a debt-
equity ratio of 2:3.

The risk free rate of return is 5%, the market risk premium is 3% and the corporation
tax rate is 40%.

Using CAPM, what would be the suitable cost of equity for Shyma to use in its
appraisal of the farm machinery project (to one decimal place)?
(ACCA F9 Financial Management December 2017)

Question 3
Backwoods is a major international company with its head office in the UK, wanting to
raise $150 million to establish a new production plant in the eastern region of Germany.
Backwoods evaluates its investments using NPV, but is not sure what cost of capital to use
in the discounting process for this project evaluation.

The company is also proposing to increase its equity finance in the near future for UK
expansion, resulting overall in little change in the company’s market-weighted capital
gearing.

The summarized financial data for the company before expansion are shown below.

Income statement for the year ended 31 December 2013

$m
Revenue 1,984

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Gross profit 432

Profit after tax 81
Dividends 37
Retained earnings 44

Statement of financial position as at 31 December 2013

Non-current assets 846
Working capital 350
1,196
Medium term and long term loans (see note below) 210
986
Shareholders’ funds
Issued ordinary shares of $0.50 each nominal value 225
Reserves 761
986

Notes on borrowings
These include $75m 14% fixed rate bonds due to mature in five years time and redeemable
at par. The current market price of these bonds is $120.00 and they have an after-tax cost of
debt of 9%. Other medium and long-term loans are floating rate UK bank loans at LIBOR
plus 1%, with an after-tax cost of debt of 7%.

Company rate of tax may be assumed to be at the rate of 30%. The company’s ordinary
shares are currently trading at $3.76.

The equity beta of Backwoods is estimated to be 1.18. The systematic risk of debt may be
assumed to be zero. The risk free rate is 7.75% and market return 14.5%.

The estimated equity beta of the main German competitor in the same industry as the new
proposed plant in the eastern region Germany is 1.5, and the competitor’s capital gearing is
35% equity and 65% debt by book values, and 60% equity and 40% debt by market values.

Required:

Estimate the cost of capital that the company should use as the discount rate for its proposed
investment in eastern company. State clearly any assumptions that you make.

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F9 Financial Management

Additional Examination Style Questions

Question 4
Droxfol Co is a listed company that plans to spend $10m on expanding its existing business.
It has been suggested that the money could be raised by issuing 9% loan notes redeemable in
ten years’ time. Current financial information on Droxfol Co is as follows.

Income statement information for the last year

$000
Profit before interest and tax 7,000
Interest (500)
Profit before tax 6,500
Tax (1,950)
Profit for the period 4,550

Statement of financial position for the last year $000 $000

Non-current assets 20,000
Current assets 20,000
Total assets 40,000

Equity and liabilities

Ordinary shares, par value $1 5,000
Retained earnings 22,500
Total equity 27,500
10% loan notes 5,000
9% preference shares, par value $1 2,500
Total non-current liabilities 7,500
Current liabilities 5,000
Total equity and liabilities 40,000

The current ex div ordinary share price is $4.50 per share. An ordinary dividend of 35 cents
per share has just been paid and dividends are expected to increase by 4% per year for the
foreseeable future. The current ex div preference share price is 76.2 cents. The loan notes are
secured on the existing non-current assets of Droxfol Co and are redeemable at par in eight
years’ time. They have a current ex interest market price of $105 per $100 loan note. Droxfol
Co pays tax on profits at an annual rate of 30%.

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F9 Financial Management

The expansion of business is expected to increase profit before interest and tax by 12% in the
first year. Droxfol Co has no overdraft.

Average sector ratios:

Financial gearing: 45% (prior charge capital divided by equity capital on a book value basis)
Interest coverage ratio: 12 times

Required:

(a) Calculate the current weighted average cost of capital of Droxfol Co. (9 marks)
(b) Discuss whether financial management theory suggests that Droxfol Co can reduce its
weighted average cost of capital to a minimum level. (8 marks)
(c) Evaluate and comment on the effects, after one year, of the loan note issue and the
expansion of business on the following ratios:
(i) interest coverage ratio;
(ii) financial gearing;
(iii) earnings per share.
Assume that the dividend growth rate of 4% is unchanged. (8 marks)
(Total 25 marks)
(ACCA F9 Financial Management Pilot Paper 2008 Q1)

Question 5
DD Co has a dividend payout ratio of 40% and has maintained this payout ratio for several
years. The current dividend per share of the company is 50c per share and it expects that its
next dividend per share, payable in one year’s time, will be 52c per share.

The capital structure of the company is as follows:

$m $m
Equity
Ordinary shares (par value $1 per share) 25
Reserves 35
60
Debt
Bond A (par value $100) 20
Bond B (par value $100) 10
30
90

Prepared by Harris Lui P. 516 Copyright @ HKSC 2018

F9 Financial Management

Bond A will be redeemed at par in ten years’ time and pays annual interest of 9%. The current
ex interest market price of the bond is $95.08.

Bond B will be redeemed at par in four years’ time and pays annual interest of 8%. The cost
of debt of this bond is 7·82% per year. The current ex interest market price of the bond is
$102·01.

Bond A and Bond B were issued at the same time.

DD Co has an equity beta of 1.2. The risk-free rate of return is 4% per year and the average
return on the market of 11% per year. Ignore taxation.

Required:

(a) Calculate the cost of debt of Bond A. (3 marks)

(b) Discuss the reasons why different bonds of the same company might have different
costs of debt. (6 marks)
(c) Calculate the following values for DD Co:
(i) cost of equity, using the capital asset pricing model; (2 marks)
(ii) ex dividend share price, using the dividend growth model; (3 marks)
(iii) capital gearing (debt divided by debt plus equity) using market values; and
(2 marks)
(iv) market value weighted average cost of capital. (2 marks)
(d) Discuss whether a change in dividend policy will affect the share price of DD Co.
(7 marks)
(Total 25 marks)
(ACCA F9 Financial Management December 2009 Q2)

Question 6 – Project-specific discount rate and limitation of CAPM

Explain how the capital asset pricing model can be used to calculate a project-specific
discount rate and discuss the limitations of using the capital asset pricing model in investment
appraisal. (11 marks)
(ACCA F9 Financial Management December 2008 Q3(c))

Prepared by Harris Lui P. 517 Copyright @ HKSC 2018

F9 Financial Management

Question 7 – WACC, project-specific discount rate, systematic and unsystematic risk

The equity beta of Fence Co is 0·9 and the company has issued 10 million ordinary shares.
The market value of each ordinary share is $7·50. The company is also financed by 7% bonds
with a nominal value of $100 per bond, which will be redeemed in seven years’ time at
nominal value. The bonds have a total nominal value of $14 million. Interest on the bonds has
just been paid and the current market value of each bond is $107·14.

Fence Co plans to invest in a project which is different to its existing business operations and
has identified a company in the same business area as the project, Hex Co. The equity beta of
Hex Co is 1·2 and the company has an equity market value of $54 million. The market value
of the debt of Hex Co is $12 million.

The risk-free rate of return is 4% per year and the average return on the stock market is 11%
per year. Both companies pay corporation tax at a rate of 20% per year.

Required:

(a) Calculate the current weighted average cost of capital of Fence Co. (7 marks)
(b) Calculate a cost of equity which could be used in appraising the new project.
(4 marks)
(c) Explain the difference between systematic and unsystematic risk in relation to portfolio
theory and the capital asset pricing model. (6 marks)
(ACCA F9 Financial Management June 2014 Q3(a), (b) & (c))

Prepared by Harris Lui P. 518 Copyright @ HKSC 2018

F9 Financial Management

Question 8 – WACC, project-specific discount rate

AMH Co wishes to calculate its current cost of capital for use as a discount rate in investment
appraisal. The following financial information relates to AMH Co:

Financial position statement extracts as at 31 December 2012

$000 $000
Equity
Ordinary shares (nominal value 50 cents) 4,000
Reserves 18,000 22,000
Long-term liabilities
4% Preference shares (nominal value $1) 3,000
7% Bonds redeemable after six years 3,000
Long-term bank loan 1,000 7,000
29,000

The ordinary shares of AMH Co have an ex div market value of $4·70 per share and an
ordinary dividend of 36·3 cents per share has just been paid. Historic dividend payments have
been as follows:
Year 2008 2009 2010 2011
Dividend per share (cents) 30.9 32.2 33.6 35.0

The preference shares of AMH Co are not redeemable and have an ex div market value of 40
cents per share. The 7% bonds are redeemable at a 5% premium to their nominal value of
$100 per bond and have an ex interest market value of $104·50 per bond. The bank loan has a
variable interest rate that has averaged 4% per year in recent years.

AMH Co pays profit tax at an annual rate of 30% per year.

Required:

(a) Calculate the market value weighted average cost of capital of AMH Co. (12 marks)
(b) Discuss how the capital asset pricing model can be used to calculate a project-specific
cost of capital for AMH Co, referring in your discussion to the key concepts of
systematic risk, business risk and financial risk. (8 marks)
(c) Discuss why the cost of equity is greater than the cost of debt. (5 marks)
(25 marks)
(ACCA F9 Financial Management June 2013 Q2)

Prepared by Harris Lui P. 519 Copyright @ HKSC 2018

F9 Financial Management

Question 9
Grenarp Co is planning to raise $11,200,000 through a rights issue. The new shares will be
offered at a 20% discount to the current share price of Grenarp Co, which is $3·50 per share.
The rights issue will be on a 1 for 5 basis and issue costs of $280,000 will be paid out of the
cash raised. The capital structure of Grenarp Co is as follows:

$m $m
Equity
Ordinary shares ($0.50 nominal) 10
Reserves 75
85
Non-current liabilities
8% Loan notes 30
115

The net cash raised by the rights issue will be used to redeem part of the loan note issue. Each
loan note has a nominal value of $100 and an ex interest market value of $104. A clause in the
bond issue contract allows Grenarp Co to redeem the loan notes at a 5% premium to market
price at any time prior to their redemption date. The price/earnings ratio of Grenarp Co is not
expected to be affected by the redemption of the loan notes.

The earnings per share of Grenarp Co is currently $0·42 per share and total earnings are
$8,400,000 per year. The company pays corporation tax of 30% per year.

Required :

(a) Evaluate the effect on the wealth of the shareholders of Grenarp Co of using the net
rights issue funds to redeem the loan notes. (8 marks)
(b) Discuss whether Grenarp Co might achieve its optimal capital structure following the
rights issue. (7 marks)
(15 marks)
(ACCA F9 Financial Management June 2015 Q4)

Prepared by Harris Lui P. 520 Copyright @ HKSC 2018

F9 Financial Management

Question 10
The managing director of Wemere, a medium-sized private company, wishes to improve the
company’s investment decision-making process by using the discounted cash flow
techniques. He is disappointed to learn that estimates of a company’s cost of capital usually
require information on share prices which, for a private company, are not available. His
deputy suggests that the cost of equity can be estimated by using data for Folten Inc, a similar
sized, quoted company in the same industry, and he has produced two suggested discount
rates for use in Wemere’s future investment appraisal. Both of these estimates are in excess of
15% per year which the managing director believes to be very high, especially as the
company has just agreed a fixed rate bank loan at 10% per year to finance a small expansion
of existing operations. He has checked the calculations, which are numerically correct, but
wonders if there are any errors of principle.

Estimate 1: capital asset pricing model

Data have been purchased from a leading business school:

Equity beta of Folten 1.4

Market return 14%
Treasury bill yield 6%

The cost of capital is 14% + (14% – 6%) × 1.4 = 25.2%

This rate must be adjusted to include inflation at the current level of 4%. The recommended
discount rate is 29.2%

Estimate 2: dividend valuation model

Average share price (cents) Dividend per share (cents)
2003 193 9.23
2004 109 10.06
2005 96 10.97
2006 116 11.95
2007 130 13.03

The cost of capital is

Where D1 = expected dividend

P0 = current market price
g = growth rate of dividend (%)

Prepared by Harris Lui P. 521 Copyright @ HKSC 2018

F9 Financial Management

When inflation is included the discount rate is 15.01%

Other financial information on the two companies is presented below:

Wemere Folten
$000 $000
Non-current assets 7,200 7,600
Current assets 7,600 7,800
Total assets 14,800 15,400

Ordinary shares (25 cents) 2,000 1,800

Reserves 6,500 5,500
Term loans 2,400 4,400
Current liabilities 3,900 3,700
14,800 15,400

Notes:
(1) The current ex-div share price of Folten Inc is 138 cents.
(2) Wemere’s board of directors has recently rejected a take-over bid of $10.6 million.
(3) Corporate tax is at the rate of 35%.

Required:

(a) Explain any errors of principle that have been made in the two estimates of the cost of
capital and produce revised estimates using both of the methods. State clearly any
assumptions that you make. (14 marks)
(b) Discuss which of your revised estimates Wemere should use as the discount rate for
capital investment appraisal. (4 marks)
(c) Discuss whether discounted cash flow techniques including discounted payback are
useful to small unlisted companies. (7 marks)
(Total 25 marks)

Prepared by Harris Lui P. 522 Copyright @ HKSC 2018