Question: Critically discuss the validity of the following statement: The capital structure choice of a firm should not be influenced by its cost structure.

06 Oct 2022,7:46 PM

 

Section 1: Multiple choice questions

 

1. Millhill Ltd. used the Net Present Value (NPV) and Internal Rate of Return (IRR) methods to evaluate an investment project that has an initial cash outlay followed by annual net cash inflows over its life. After completing the evaluation, it was discovered that the cost of capital of the project had been miscalculated and that the correct cost of capital was in fact higher than that used. What will be the effect on the project’s NPV and IRR once correcting for this error?
2. Both NPV and IRR will decrease.
3. Both NPV and IRR will increase.
4. NPV will decrease and IRR will remain unchanged.
5. NPV will increase and IRR will remain unchanged.

[20 marks]

 

2. In June 2021, Calman Co. had a share price of £49.10, a market-to-book ratio of 4.16, and 56.7 million shares outstanding. In addition, Calman had £750 million of total liabilities, £170.1 million in net income, and cash of £255 million. Calman’s book value of equity is closest to:
3. £952.2 million
4. £669.2 million
5. £11.58 billion
6. £2.03 billion

[20 marks]

 

3. The weighted average cost of capital approach is based on the assumption that new project opportunities have similar levels of ________ as existing projects.
4. risk
5. leverage
6. initial investment
7. duration

[20 marks]

 

4. The level of net working capital is affected by all but which of the following:
5. account receivables
6. cash
7. retained earnings
8. tax payables

[20 marks]

 

5. Which of the following statement is correct about dividends per share?
6. Increase as the net income increases as long as the number of shares outstanding remains constant.
7. Decrease as the number of shares outstanding decrease, all else constant.
8. Are inversely related to the earnings per share.
9. Are equal to the amount of dividends distributed to shareholders divided by the number of shares outstanding.

[20 marks]

 

 

Section 2: Essay questions

answer any 2 of the 4 questions

 

Question 1.

 

Part 1.

 

Happy Home is considering introducing a new set of living room sofa (“Comfi Fabric Corner”) to complement its existing product line. You are the Chief Financial Officer of Happy Home and are tasked to evaluate the feasibility of this project.

 

The projected revenues and costs associated with this investment are as follows:

 

1. After a market research costing the firm £10,000, a selling price of £5,000 per set of sofas has been agreed. Variable production costs will amount to 45 percent of the selling price, and fixed costs are £1 million per year.

 

2. Sales will be 2,000, 2,500, 3,000, 2,000 and 1,800 sofa sets per year for years t=1, 2, 3, 4, and 5, respectively. A new range of product will replace this sofa set at the end of the 5^th

 

3. One area of concern is that the selling of the new sofas will reduce the company’s existing traditional dining table product (“Royal Oak”). It is estimated that sale of “Royal Oak” will go down from 10,000 units per year to 9,000 units per year. The “Royal Oak” sells for £2,000 per unit and has a variable production cost amounting to 40 percent of the selling price.

 

4. To produce the sofas, the company needs to make an initial investment of £10 million in equipment. The equipment is depreciated to zero book value over the 5-year period using the straight-line method. At the end of the 5th year, the equipment will be sold at a market price of £2 million.

 

5. Changes in working capital requirements: Cash increases by 5% of the change in sales; inventory increases by 5% of the change in sales; trade receivables increase by 5% of the change in sales; and trade payables increase by 5% of the change in variable production costs. These working capital requirements are company-level policies and are applicable to both the sofa sets and the dining tables. Working capital will be required at the end of year 1 and will be released later.

 

6. All revenues and expenses are paid in cash in the year they incur.

 

7. The corporate tax rate is 40 percent.

 

8. The project has a beta of 1.5, the risk-free rate is 3% and the market risk premium is 6%.

 

Requirements:

 

1. Calculate the Net Present Value and the Payback Period of this project. [65 marks]

 

1. Advise the Chief Executive Officer of Happy Home on whether the company should undertake this investment. In your answers, you may want to comment on the feasibility of the project and discuss other factors that may influence the decision. [10 marks]

 

 

Part 2.

“Over the last 15 years, 94% of corporate profits have gone to shareholders in the form of buybacks and dividends, instead of to workers and their families. The practice of corporate stock buybacks does not just drive inequality — it drains resources for investment in workers, research and development, and the long-term growth of companies.”

 

Critically discuss these statements.                                                                                                [25 marks]

 

 

 

Question 2.

 

Part 1.

In a recent article published in the Review of Corporate Finance Studies, Albuquerque et al (2020) find that firms with higher Environmental and Social (ES) ratings have significantly higher returns, lower return volatility, and higher operating profit margins during the first quarter of 2020 when the Covid-19 pandemic first occurred. Firms with high ES ratings are those that (i) thrive to protect the environment by reducing their toxic emissions and making efficient use of natural resources, and those that (ii) support social causes by fostering workplace and product safety, community development, and human rights.

 

Albuquerque, R., Koskinen, Y., Yang, S. and Zhang, C., 2020. Resiliency of environmental and social stocks: An analysis of the exogenous COVID-19 market crash.  Review of Corporate Finance Studies, 9(3), pp.593-621.

 

Requirements:

Critically discuss how this paper’s findings inform our debate about shareholder- versus stakeholder-oriented model of corporations.

 

Hint: In your answers, you can consider responding to the following questions:

1. What are the different views on the overall objective of the firm?
2. What are the potential reasons of firms with high ES ratings outperforming other firms when the Covid-19 pandemic first occurred?

• Should a firm only seek to create value for its shareholders, or should it care about the balance between the legitimate interests of all stakeholders (e.g., employees, customers, suppliers, the society, the environment)?

1. How do major crises such as the 2008-2009 Global Financial Crisis and the Covid-19 pandemic reshape the overall objective of the firm?
2. Under what circumstances would the emphasis on stakeholders’ benefits harm shareholders’ wealth?

 

[80 marks]

 

Part 2.

Suppose that the market portfolio is equally likely to increase by 24% or decrease by 8%. Security "X" goes up by 29% when the market goes up and goes down by 11% when the market goes down. Security "Y" goes down by 16% when the market goes up and goes up by 16% when the market goes down. Security "Z" goes up by 4% when the market goes up and goes up by 4% when the market goes down. What is the expected return on a security with a beta of 1.2 in this economy?                                                    [20 marks]

 

 

Question 3.

 

Part 1.

Niklas is asked to estimate the cost of equity capital for Ariston holdings, a listed firm in Zimbabwe that sells agricultural products. Zimbabwe is a country in Africa, which has an average inflation rate of 150% in the past three years. Niklas made the following estimations:

 

1. The risk-free rate is the ten-year Zimbabwean Government bond rate.
2. The market risk premium is the ten-year historical difference between the average returns on ZSE All Share Index, a market index consisting of 63 listed firms in Zimbabwe, and the ten-year Zimbabwean Government bond rate.
3. The beta for Ariston is the average beta of other global firms that sell similar agricultural products.

 

Requirements:

1. What are the potential errors in Niklas’ estimation of Ariston’s cost of equity capital?

[25 marks]

 

1. What advice would you give Niklas to fix these errors?                       [15 marks]

 

 

Part 2.

Petrol Steel is a highly levered company with 20 million shares, trading at £10 per share and £800 million in debt outstanding.

 

The pre-tax cost of debt for the company is 10%, the corporate tax rate is 40% and the levered beta for the company is 3.06. The risk-free rate is 3% and the market risk premium is 5%.

 

Requirements:

1. What is the firm’s current weighted average cost of capital? [10 marks]

 

7. A bondholder in the firm is willing to accept 20 million newly issued shares in the company in exchange for £200 million in debt (which will be retired). This transaction will raise the company’s bond rating to BBB and lower their pre-tax cost of debt to 7.5%. Estimate the new cost of capital if the company agrees to this deal. [20 marks]

 

1. Assume that the company agrees to the swap of equity for debt (from part b). Further assume that the firm is in perpetual growth, growing 2% a year forever, what is the company’s share price after the transaction? [30 marks]

 

 

Question 4.

 

Part 1.

1. Critically discuss the validity of the following statement: The capital structure choice of a firm should not be influenced by its cost structure.

[25 marks]

 

1. In a period of high volatility, Fusion Ltd is considering to invest in a new project that will significantly increase fixed costs. The implementation of the project would require a large amount of additional debt. Discuss the risk implications of the project and the reasons that might induce Fusion to re-consider the investment.

 

[15 marks]

 

 

1. Explain how your answer might change if Fusion decides to employ only equity to fund the project and the economy is booming.

 

[15 marks]

 

 

 

Part 2.

 

Fusion Ltd shows the following business and accounting information:

	Base Year	Year 2
Quantity sold	11,000	11,500
Price per unit	13	13
Variable cost per unit	7	7
Salaries	20,000.00	20,000.00
Depreciation Costs	25,000.00	25,000.00
Other Fixed Costs	10,000.00	10,000.00
Tax Rate	15%	15%

 

1. Compute the degree of operating leverage of the company using two different approaches and discuss the information content of each approach.

[20 marks]

 

1. Assume that the company has a credit line of £20,000 and each year uses £12,500 of this credit by paying an annual interest rate of 4%. Compute:

 

• The degree of financial leverage of Fusion using two different approaches and discuss the different information content of each approach.

[15 marks]

 

• The degree of combined leverage for Fusion using three different approaches and interpret your result.

[10 marks]