Question: Critically evaluate the main methods that companies use to calculate their cost of equity capital. Explain the strengths and weaknesses of each method.

Question 1

LEO Ltd is a small, listed entity based in a country in the eurozone. Its principal activity is haulage. Head office and key operations are located in the home country. The company operates a large number of articulated vehicles and revenues are generated in euros.

Due to a shortage of lorry drivers during the recent global pandemic and the operating shock from the UK’s decision to leave the European Union, the group believes there is significant scope to expand its operations through acquiring new vehicles and hiring drivers.

To expand its operations, the company requires the use of 100 additional vehicles, which would increase the size of theexistingfleet by50 per cent. LEO is considering the following choice of payment methods to acquire the use of the new articulated vehicles (information is given on a per-vehicle basis):

Purchase asset

Pay the whole capital cost of €200,000 on 1 December 2021, funded by bank borrowings. If LEO follows this approach they will be required to pay on-going consultation and maintenance costs annually at the end of each year. These costs are forecast to be of the order of €10,000 in the first year and to increase by5 per cent eachyear due to inflation. Fuel costs are anticipatedtobe €20,000 per annum per vehicle and increase at 3 per cent per annum over the next five years.

The vehicles are expected to have little or no resale value after five years although they could still be usable within the entity or be sold in the second-hand market at this time. If the firm continues to operate the vehicles for more than five years, it is expected that maintenance costs will increase significantly in older vehicles. Given the uncertainty in resale / re-use after five years the company has not provided any costings or financial data after this point.

Operating Lease

Enter into an operating lease with the manufacturer of the vehicles. Lease payments are made in advance and the firm will be required to pay an amount of €50,000 immediately on 1 December 2021. A further four annual payments will be made at the start of each year of the five-year lease period and the lease payment will increase at a rate of 8 per cent each year. This fee will include annual maintenance. Under the terms of the operating lease the company would remain response for fuel costs as described for Method 1.

At the end of five years there is an option to continue the lease agreement for a further three years, paying for maintenance on a time and materials basis. This has not been costed.

Other information

Due to the reduction in central bank rates and the known shortage of supply in the industry, banks are competing to lend to LEO and the company is able to borrow at a secured interest rate of 5 per cent per year. The entity is liable to pay tax at a marginal rate of 30 per cent, payable 12 months after the end of the accounting year in which the liability arises. This rate is not expected to change. The weighted average cost of capital for investment projects relating to the use of these vehicles is 10 per cent. The company’s financial year end is 30 November each year. Tax depreciation on the capital cost is available on areducingbalancebasis at arateof25per cent over thefiveyears ofoperation.

There is significant uncertainty in the haulage industry as of today. There is an expected long-term shortage of lorry drivers and vehicles for the foreseeable future. However, there is uncertainty over how long this shortage is expected to last and the role of industry competition in resolving this shortage. Some industry experts believe the shortage of lorry drivers reflects a long-term requirement for more long-haul drivers and vehicles, while others believe this is likely to a medium term event and the higher demand seen today will decline over the next several years.

a) Calculate the net advantage to leasing and recommend which payment method is expected to be cheaper for LEO in present value terms.

(20 marks)

b) Discuss the real options inherent in this project and how risks associated with these are affected bythe choice of leasing or purchasing the assets. (10 marks)

(Total 30 marks)

Question 2

Bracken Inc is a publicly traded entity listed on the NASDAQ exchange in the United States. The company specialises in pet food manufacturing. The company has traditionally relied on equity financing for its long-term funding needs and has zero long-term debt on its balance sheet. However, following the interest rate cuts seen during the recent global pandemic the company is considering a financial restructuring in order to take advantage of the ‘cheaper’ cost of debt financing today.

Under the proposed restructuring, Bracken Inc would issue long-term perpetual debt and use the proceeds to repurchase stock. The company would plan to issue debt to raise $500million and buyback stock to the same value at the current market price. Bracken Inc’s shares are trading at a price of $10.00 per share and the company currently has 125million shares in issue. The interest rate on debt will be 5 per cent. Bracken Inc is expected to generate earnings before interest and taxes (EBIT) of $200million in perpetuity. The corporate tax rate is 30 per cent.

Assuming that all cash flows are constant in perpetuity, you have been asked to provide the following information to the company’s board of directors:

a) An estimate of the firm’s earnings per share under the current capital structure and the proposed debt issue and stock buyback.

(4 marks)

b) Estimate the level of EBIT where the firm will be indifferent between the proposed financing policies.

(4 marks)

c) Determine the cost of equity capital for Bracken Inc before the proposed restructuring.

(3 marks)

d) What is the value of the firm and of the firm’s equity after the capital restructuring?

(3 marks)

e) Calculate the geared cost of equity capital and the weighted average cost of capital for Bracken Inc following the proposed restructuring.

(4 marks)

f) Comment on the view that Bracken Inc can maximise its value and minimise its cost of capital by employing a very high level of debt financing with specific reference to the financial environment facing the firm during and after the global pandemic.

(12 marks) (Total 30 marks)

Question 3

As the financial manager of Baird Plc you have been asked to evaluate the company’s options with regards to a new equity offering. The company has experienced a decline in revenue in 2020 and 2021 during the economic crisis but the directors believe that the firm has a long-term sustainable business model that will be successful once the economy rebounds.

Baird Plc currently has 250million shares in issue at a current market price of 75p per share. The company plans to raise £125million of new equity. The company’s investment bank has put forward the following proposals to the board:

i. A rights offering at a 1/3 discount to the current market price.

ii. A deep-discounted rights offering at a 60 per cent discount to the current market price.

Baird Plc’s management is leaning towards using the deep discounted rights offering due to the poor financial market conditions the company has experienced over the past two years. However, the board of directors is concerned about the potential dilutive effect of the offering on the firm’s earnings per share (EPS). Once business conditions return to normal, the firm expects to generate long-term net income after-tax of £50m per annum.

a) Set out the terms of the rights offering for i and ii.

(6 marks)

b) Use the earnings per share and earnings yield calculations to determine whether the deep discounted offering is dilutive to EPS and shareholder’s wealth.

(6 marks)

c) Explain why the company may prefer a deep discounted offering during a period of financial market volatility and a downturn following the recent global pandemic.

(3 marks) (Total 15 marks)

Question 4

Bolt Plc is expected to declare earnings of £25million for the next financial year. Analysts believe that the company will reinvest 60 per cent of its earnings next year, 50 per cent the following year, 50 per cent in year three, and from year four onwards the firm will reinvest 40 per cent of its earnings.

The internal rate of return on new investment projects is expected to be 40 per cent for investments made at the end of year one, falling to 30 per cent in year two, 25 per cent in year three, and thereafter will remain steady at 18 percent for investments made from year four onwards.

The company can be valued using a discount rate generated from the capital asset pricing model (CAPM). The risk-free rate is currently 1 per cent, the expected market risk premium is 8 per cent, and the firm has an equity beta of 1.5.

Required:

a) Calculate the required return on the firm’s shares using the CAPM

(2 marks)

b) Prepare a schedule of dividends, reinvested earnings, incremental earnings, and the net present value of new investment projects for Bolt Plc in years one to four.

(5 marks)

c) Value the company using the dividend discount model.

(4 marks)

d) Value the company using the earnings-based valuation method.

(4 marks) (Total 15 marks)

Question 5

Thunder Plc is a publicly traded company. You currently hold 5,000 shares in the firm and are unsatisfied with the current dividend policy of the firm. The company is expected to announce that it intends to pay a dividend of $3.00 per share for thecurrentfinancial year. You wouldprefer thatthecompanyadopted a higher dividend policy and paid out $5.00 per share.

Required:

a) Explain the processyou could take asan investor to create a homemade dividend in line with your preferred payout policy for the firm, showing any relevant numerical workings.                 The share price prior to the announcement of the proposed $3.00 dividend is $60 per share.

(6 marks)

b) The intended dividend of $3 per share would be paid from earnings per share of $10. The company has a long-term target payout ratio of 40 percent or earnings and a speed of adjustment factor of 0.6.

i.     Assuming earnings per share of $12, $14, $15, and $16 in years two to five respectively, and assuming the firm proceeds with the $3 dividend at time one, determine the expected value of the firm’s dividends in years two to five under the Lintner dividend model.

(4 marks)

ii.     If Thunder Plc continues to earn $16 per share for the long-term future what will the dividend of the company tend towards?

(1 mark)

iii.     Explain the determinants of the long-term payout ratio and the speed of adjustment factor under the Lintner model.

(4 marks) (Total 15 marks)

Question 6

Explain the main strategies that firms can employ for the management of their net working capital, from very aggressive to very conservative policies. Your answer should explain how UK firms may be expected to adjust their working capital policy in 2021 as a result of Brexit, the Covd-19 pandemic, and supply shortages facing UK retailers.

(20 marks) (Maximum 800 words)

Question 7

Describe the main mechanisms that UK quoted companies can use to raise equity through a seasoned equity offering (SEO).

(20 marks) (Maximum 800 words)

Question 8

Explain and provide examples of the direct and indirect costs of bankruptcy. Explain how such are such costs expected to change during a financial market crisis, such as a global financial crisis or a pandemic.

(20 marks) (Maximum 800 words)

Question 9

Critically evaluate the main methods that companies use to calculate their cost of equity capital. Explain the strengths and weaknesses of each method.

(20 marks) (Maximum 800 words)