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Valuation and Capital Budgeting for the Levered Firm

1. ABC Plc. is a manufacturer of household appliances with annual after-tax profits of £5 million. Its share price is currently trading at £6.The firm has a book value of equity of £20 million and a book value of debt of £40 million. Currently, it has 10 million shares outstanding. The company's cost of debt (before tax) is 6 percent and the beta of the company stock is 1.5. The risk-free rate is 3 percent and the expected market risk premium is 5.5 percent. The marginal tax rate is 40 percent.

(a) What is ABC Plc.'s after-tax weighted average cost of capital (WACC)?
(b) ABC is considering increasing its dividend payout to shareholders in the future and therefore plans to raise debt this year. If the company issues additional debt of £20 million, what would be the effect on the firm's WACC? Please explain your results. You can assume that the cost of debt stays the same
(c) A close competitor to ABC, Lynix Plc., currently has after-tax earnings per share of £1.20 and trades at a share price of £10.80. Which firm is valued higher by the market and what could be possible reasons for the difference in valuations? Briefly explain the valuation methodology you used and how it compares to discounted cash flow methods?

2. A quoted company has a price-to-book-value ratio of 2 and 20 million shares outstanding, each with a book value of £10. The firm's cost of equity is 12% and its cost of debt is 5%. Assume capital markets are perfect except for the fact that firms pay corporation tax of 35%.

The company balance sheet stated at book values is as follows:
Cash 20
Fixed Assets 280
Total Assets 300
Equity 200
Debt 100
Total 300

(a) What is the change in the firm's cost of equity if the firm issues new shares in order to repay half its debt? Explain why the cost of equity changes.
(b) Describe the two main theories of capital structure and how they explain observed differences in financial leverage across firms and industries.
(c) Briefly describe two ways in which a firm's investment policy can be adversely affected by financial distress

(a) As a CFO of a publicly quoted company, what factors would you take into account when deciding whether to distribute surplus cash to shareholders in the form of dividends or via a share repurchase

(b) Why do venture capitalists buy convertible preferred stock?

(c) A firm is considering an issue of a perpetual bond of £60 million at 6% per annum in order to buy back equity. Corporate profits are taxed at 30%; otherwise assume capital markets are perfect. It has the following balance sheet stated at market values (£m):

Networking Capital 20
Other Assets 180
Total 200

Equity & Liabilities
Equity 200
Total 200

What would be the effect on shareholder wealth of issuing the bond?
What will the post-buyback balance sheet at market values look like?
What would be the effect on shareholder wealth if individual investors who face a personal tax rate of 20% own the equity?

Solution Summary

This response focuses on corporate finance and provides instruction aid on valuation and capital budgeting.