Corporate FinanceWorkshop 1

2 April 2014Jan Wallner

Introduction• 10 Workshops

– 2 TAs with 5 workshops each– Usually from 9:00 to 10:45 on a Wednesday (but not always, check your timetable!)- Please practice beforehand!

• End-of-chapter exercises covered are listed in the course manual • Ask questions!

– During the Workshop– Before or after the workshop or during the break

• Discussion Board- Questions regarding exercises- But also conceptual questions if necessary- (Email: 357599jw@student.eur.nl) discussion board preferred!

Some Advice• Try to really get an understanding of the concepts• Practice on Connect• Focus on assigned exercises• Exam discrimates well between students who studied and those who did not

Today‘s Plan• Exercise 12.32: WACC• Exercise 12.35: Finding the WACC• Exercise 14.17: Equity Accounts• Exercise 15.13: Break-even EBIT• Exercise 15.22: Calculating WACC• Exercise 15.30: Cost of Capital

Exercise 12.32 – WACC We are given the following for Kose SA:• Debt-equity ratio: 0.80• WACC: 10.5 %• Tax rate: 35 %a) If Kose‘s cost of equity is 15 %, what is ist pre-tax cost of debt?Formula for WACC: First need to determine debt and equity weights:

Exercise 12.32 – WACC Now, we can plug into our formulaRearranging: b) If the after-tax cost of debt is 6.4 %, what is the Cost of Equity?Rearranging:

Exercise 12.35 – Finding the WACC We are given the following for Titan Mining Corp:• 9 million shares of equity• 1,200,000 8.5 % semi-annual bonds outstanding with a par value of £ 100• Share price: 34 £• Equity beta: 1.20• Bonds have 15 years to maturity and sell for 93 % of par• The market risk premium is 10 %, T-bills are yielding 5 %• Tax rate is 28 %If you are given so much information, a useful first step is to sort it.

Exercise 12.35 – Finding the WACC • Equity

– 9 million shares– Share price: 34 £– Equity beta: 1.20– Market risk premium: 10 %– T-bill rate: 5 %

• Debt– 1,200,000 bonds– 8.5 % coupon with semiannual payments– Maturity: 15 years– Par value: 100 – Sell for 93 % of par

• Tax rate: 28 %a) What is the firm’s market value capital structure?

If you read „market risk premium“ and „T-bill rate“, always think CAPM}

Exercise 12.35 – Finding the WACC a) What is the firm’s market value capital structure? MVEQUITY = Shares * Share Price:

MVDEBT = Bonds * Bond Price:

MVFIRM =

Weights of debt & equity:

h𝑊𝑒𝑖𝑔 𝑡𝑑𝑒𝑏𝑡=111 ,6 00,000417,600,000 =0. 2672

Exercise 12.35 – Finding the WACC a) If Titan Mining is eveluating a new investment project that has the same risk as the firm’s typical project what rate should the firm use to discount the project’s cash flows?Finding the cost of debt:Debt: 1,200,000 8.5 % coupon bonds outstanding, par value £100, selling for 93% of par, bonds make semi-annual paymentsThe pre-tax cost of debt is the YTM of the bonds

Using a financial calculator we find: In Excel the function to calculate YTM is "=rate()"

Bond yields 0.0469 every six months, hence bond‘s YTM (quoted per year) is :

Exercise 12.35 – Finding the WACC Finding the cost of equity:Market: 10 % market risk premium, 5 % risk-free rate, equity beta is 1.20We apply the CAPM to find the expected return on equity:

Exercise 12.35 – Finding the WACC Finding the WACC:

Plugging into the formula:

Exercise 14.9 – Par ValuesInternational Energy plc was formed in 1912 with 100,000 shares of equity with a £1 par value. Today, the company’s share price is £9 and retained earnings are £213,000. International Energy has just decided that it wishes to issue 25,000 new shares.

We are asked to find: • Total par value• Additional paid-in capital• Book value per share

Exercise 14.9 – Par ValuesInternational Energy plc was formed in 1912 with 100,000 shares of equity with a £1 par value. Today, the company’s share price is £9 and retained earnings are £213,000. International Energy has just decided that it wishes to issue 25,000 new shares. Equity before share issue:

Addition through issue

Ordinary Shares (100,000 at £1 par value) 100,000Additional Paid In Capital 0

Retained Earnings 213,000

Equity Value 313,000

Ordinary Shares (25,000 at £1 par value) 25,000

Additional Paid in Capital (25,000 x (£9 - £1)) 200,000  

  Retained Earnings 0 

  Equity Value 225,000

Exercise 14.9 – Par ValuesEquity before share issue:

Addition through issue

Adding up: • Total par value = 100,000 +25,000 = 125,000• Additional paid-in capital = 200,000

Ordinary Shares (100,000 at £1 par value) 100,000Additonional Paid In Capital 0

Retained Earnings 213,000

Equity Value 313,000

Ordinary Shares (25,000 at £1 par value) 25,000

Additional Paid in Capital (25,000 x (£9 - £1)) 200,000  

  Retained Earnings 0 

  Equity Value 225,000

Exercise 14.9 – Par Values• Book value per share after the issue

Total equity = 313,000 + 225,000 = 538,000Number of Shares: 100,000 + 25000 = 125,000

Exercise 15.13 – Break-even EBITHammerson plc pays no taxes and compares two different capital structures:• Plan 1

– All-equity, 712 million shares• Plan 2

– Leveraged, 475 million shares, £ 1 billion in debt outstanding with 5 % interest

a) If EBIT is 459 million, which plan will result in higher EPS?Plan 1: 459 million / 712 million = 0.647 Plan 2: (459 million – 50 million) / 475 million = 0.861 (higher EPS)b) If EBIT is 80 million, which plan will result in higher EPS?Plan 1: 80 million / 712 million = 0.112 (higher EPS)Plan 2: (80 million – 50 million) / 475 million = 0.063

Exercise 15.13 – Break-even EBITc) What are the break-even EBIT?(i.e. EBIT for which both capital structures yield the same EPS)

We just equate:

Exercise 15.22 – Calculating WACCShadow plc has no debt but can borrow at 8 per cent. The firm’s WACC is currently 12 per cent, and the tax rate is 28 per cent.a) What is Shadow‘s cost of equity? 12%, why ? b) If the firm converts to 25 per cent debt, what will its cost of equity be?

c) If the firm converts to 50 per cent debt, what will its cost of equity be?

Exercise 15.22 – Calculating WACCShadow plc has no debt but can borrow at 8 per cent. The firm’s WACC is currently 12 per cent, and the tax rate is 28 per cent.d) What is Shadow’s WACC in requirement b? In requirement c?Let‘s look at b first:

And c:

Exercise 15.30 – Cost of CapitalAcetate:MV Equity = 20 millionMV Debt = 10 millionTreasury bills yield 8 % per yearExpected return on market portfolio is 18 %The beta of Acetate‘s equity is 0.9

a) What is Acetate’s debt–equity ratio?Debt-equity ratio =

Exercise 15.30 – Cost of CapitalAcetate:MV Equity = 20 million; MV Debt = 10 million; Treasury bills yield 8 % per year; expected return on market portfolio is 18 %; the beta of Acetate‘s equity is 0.9b) What is Acetate’s WACC?Cost of Equity: Again, we use the CAPM

Cost of Debt:In this exercise we are in the Modigliani-Miller world and assume that debt is risk-free, hence, we use the T-bill rate: 8 %

Calculating the WACC:

Exercise 15.30 – Cost of CapitalAcetate:MV Equity = 20 million; MV Debt = 10 million; Treasury bills yield 8 % per year; expected return on market portfolio is 18 %; the beta of Acetate‘s equity is 0.9c) What is the cost of capital of an otherwise identical all-equity firm?14 %, why?

We can also prove this mathematically with MM‘s formula:

Thank you very much for your attention I will stick around for questions …