Tutorial 4

BS97318
Corporate Finance
Tutorial 4
MSc Finance and Accounting
Adrian Lam
y.lam16@imperial.ac.uk
Imperial College London
November 6, 2019
Logistics Tips Wrap-up Exam-style Questions
Plan for Today
1 Coursework 2: Guidelines and FAQ

2 Coursework 2: Tips
Roadmap
Leveraged Buyback
Optimal Debt Ratio
Adjusted Present Value Rule
Adrian Lam (Imperial College) Tutorial 4 November 6, 2019 1 / 37

Coursework 2: Guidelines
File Names and Layout

State your group number in the document
Highlight final answers in colour
Practical Problems
No right or wrong answers
Show clear logic (i.e. explain what you are doing and how you are
doing it)
State formulas
State and justify the numbers you use
Go and explore!

Leveraged Buyback
What is the question we have in mind?

How does a change in capital structure affect shareholder value?
Should we issue debt to buy stock back?
If it lowers the cost of capital, then go ahead
Using the incremental value approach
With enterprise value EV , weighted average cost of capital rC , growth
rate g , debt D and with ∆ denoting changes, we apply the perpetuity
formula to calculate the change in value
Annual cost savings
z }| {
(EV × ∆rC )
∆EV =
rC0 − g

Leveraged Buyback
What information do we have?

Cost of capital is the weighted average of cost of equity and after-tax
cost of debt
E D
rC = × rE + × (1 − t) × rD
D +E D +E
Change in enterprise value through changes in capital structure is the
present value of change in financing costs
(EV × ∆rC )
∆EV =
rC0 − g
What is the problem from a mathematical point of view?

Solving a system of equations

Share Buyback: An Example
Lam and Li Inc.

Lam and Li Inc. is a publicly traded company involved in selling phones.
The company has 15 million shares outstanding trading at $10 per share
with a beta of 1.1. Suppose Lam and Li Inc. is purely equity-financed.
The risk-free rate is 4.5% and the market risk premium is 4%. The market
concensus for the firm’s long term growth rate is 3%. The marginal tax
rate is 40%.
1 Estimate the current cost of capital for Lam and Li Inc.
2 Lam and Li Inc. announces that the firm will borrow $50M to do a
share repurchase. The company can raise debt at a pre-tax cost of
5%. Estimate the impact on share price.

Lam and Li Inc.

Estimate the current cost of capital for Lam and Li Inc.
What is the current cost of capital?

Since Lam and Li Inc. has no debt, the cost of capital is the cost of
equity
By applying the CAPM formula,
rE =rf + β × ERP = 4.5% + 1.1 × 4.0% = 8.9%

Lam and Li Inc.

Lam and Li Inc. announces that the firm will borrow $50M to do a share
repurchase. The company can raise debt at a pre-tax cost of 5%. Estimate
the impact on share price.
What is the new beta β 0 ?

With new level of debt D 0 and new level of equity E 0 , we can express
the new level of beta, i.e. the levered beta, β 0 as
D0

50
β 0 = β × 1 + (1 − t) 0 = 1.1 × 1 + 0.6 × 0
E E
33
= 1.1 + 0
E

What is the new cost of equity rE0 ?
rE0 = rf + β 0 × ERP

33
= 4.5% + 1.1 + 0 × 4%
E
1.32
=8.9% +
E0

What is the new weighted average cost of capital wC0 ?
D0 E0
rC0 = × (1 − t) × rD + × rE0
D0 + E 0 D0 + E 0
E0

50 1.32
= × (1 − 0.4) × 5% + × 8.9% +
50 + E 0 50 + E 0 E0
1.5 + 0.089E 0 + 1.32
=
50 + E 0
Simplifying, we can write rC0 as
2.82 + 0.089E 0
rC0 = (1)
50 + E 0

What about new level of equity E 0 ?

Using the change in firm value formula,
EV × ∆rC
∆EV =
rC0 − g
150 × (8.9% − rC0 )
E 0 − E + ∆D =
rC0 − 3%
150 × (8.9% − rC0 )
E 0 − 100 =
rC0 − 3%
Simplifying, we can write rC0 as
10.35 + 0.03E 0
rC0 = (2)
50 + E 0

Combining equations (1) and (2), we can solve for E 0
2.82 + 0.089E 0 10.35 + 0.03E 0

rC0 = =
50 + E 0 50 + E 0
Simplifying, we get
E 0 = $127.63M

What is the new weighted average cost of capital?

By plugging E 0 into equation (1),
2.82 + 0.089E 0
rC0 = = 7.98%
50 + E 0
What is the impact on share price?
Assuming the share repurchase benefits all shareholders equally, with
share price (P) and number of shares outstanding (N), we can write
the change in price as
∆EV $127.63M − 150M + 50M

∆P = =
N 15
= $1.82

Share Buyback: Approximate Solution
What is the current WACC?
rC = rE =rf + β × ERP = 4.5% + 1.1 × 4.0% = 8.9%
What is the new level of equity?

Assuming the new level of equity is E - D 0
E 0 = E − D0
= 150 − 50
= 100

What is the new return on equity?

0 50
rE = 4.5% + 1.1 × 1 + (1 − 0.4) × 4.0%
100
= 10.22%
What is the new WACC?

50 100
rC0 = × (1 − 0.4) × 5.0% + × 10.22%
100 + 50 100 + 50
= 1.0% + 6.8%
= 7.8%

What is the change in share price?

∆EV $150M × (8.9% − 7.8%) 1
∆P = = ×
N 7.8% − 3.0% 15M
= $2.29

Optimal Debt Ratio
Senndynamics’ Optimal Debt Ratio

Senndynamics is a manufacterer of headphones and is considered to be
highly levereaged. The firm has $237M in market value of debt. Its book
value of equity is $250M, and its stock price is $19.88 per share, with 11M
shares outstanding. As a consumer electronics company, it is quite
responsive to the market and has a beta of 1.26. The firm has an
operating profit of $44M. The equity risk premium is 5.5%, the treasury
bond rate is at 7.88%, and the marginal tax rate is 37%.
Using the bond ratings information below, estimate the optimal debt ratio,
using the cost of capital approach.

Optimal Debt Ratio
Debt Ratio Bond Rating Interest Rate on Debt

0% AAA 8.18%
10% AAA 8.18%
20% A+ 8.88%
30% A 9.13%
40% A- 9.38%
50% BB 10.38%
60% BB 10.38%
70% B 11.88%
80% B- 12.88%
90% CCC 13.88%

Optimal Debt Ratio
What is the optimal debt ratio?

The debt ratio that makes weighted average cost of capital lowest!
We want to minimise
E D
rC = × rE + × (1 − t) × rD
E +D E +D
What do you need to evaluate this?
Cost of equity at different debt ratios (i.e. different levered betas)
After-tax cost of debt at different debt ratios
Use Excel to help us

Optimal Debt Ratio
Debt Ratio D/E Ratio β0 rE rD, After-tax rC

0% 0.00 0.75 12% 5.15% 12.01%
10% 0.11 0.80 12% 5.15% 11.58%
20% 0.25 0.87 13% 5.59% 11.24%
30% 0.43 0.95 13% 5.75% 10.91%
40% 0.67 1.07 14% 5.91% 10.61%
50% 1.00 1.22 15% 6.54% 10.57%
60% 1.50 1.46 16% 6.54% 10.28%
70% 2.33 1.85 18% 7.48% 10.66%
80% 4.00 2.64 22% 8.11% 10.97%
90% 9.00 5.00 35% 8.74% 11.41%

Adjusted Present Value Approach
The adjusted present value approach says that value of a levered firm
can be expressed as the sum of (1) value of unlevered firm and (2)
effect of debt on value
VL = VU
|{z}
Value of firm without debt
+ PVInterest tax shield − PVFinancial distress cost
| {z }
Effect of debt on firm value

APV Approach: An Example
Taxi Co.
Taxi Co. has $985M debt outstanding and 40M shares trading at $46.25
per share. Its operating profit is $203M, and its marginal tax rate is
36.5%. Taxi Co. is interested in estimating its optimal leverage and has
asked F&A Consulting LLC for advice.
Given the following information on bond ratings and that the direct and
indirect bankrupty costs are estimated to be 25% of firm value, what is
the optimal debt ratio of firm?

Debt Ratio Bond Rating Probability of Default

0% AAA 0.28%
10% AAA 0.28%
20% A- 1.41%
30% BB 12.2%
40% B- 32.5%
50% CCC 46.64%
60% CCC 65%
70% C 80%
80% C 80%
90% D 100%

We need to use this formula
VL = VU + PVInterest tax shield − PVFinancial distress cost
What is the value of levered firm?
VL = VD + VE = $985M + $46.25 × 40
= $2835M
What is the present value of interest rax shield?
PVInterest tax shield = VD × t = $985M × 36.5%

= $359.525M

What is the present value of financial distress cost?
PVFinancial distress cost = Probability of default

× Value of financial distress
= Probability of default
× 25% × (V + PVInterest tax shield )
| U {z }
Firm value net of financial distress cost
i.e., we need to find the current probability of default, which depends

on debt ratio, and the value of financial distress

What is the current debt ratio (DR)?
D 985
DR = =
FV 2835
= 35%
What is the probability of default (πDR ) with DR = 35%?

(Assume we can use linear interpolation to estimate probability of
default)
π20% + π40% 12.2% + 32.5%

π35% = =
2 2
= 22.35%

What is the value of the unlevered firm?
VU = VL − PVInterest tax shield + PVFinancial distress cost

VU = $2835M − $359.525M + 22.35% × 25% × (VU + $359.525M)
VU = $2643.25M

Debt Ratio VU Tax Savings Bankruptcy Cost VL

0 2643.25 0.00 0.00 2643.25
0.1 2643.25 96.48 2.04 2737.69
0.2 2643.25 192.96 11.18 2825.03
0.3 2643.25 289.44 104.80 2827.88
0.4 2643.25 385.91 300.67 2728.49
0.5 2643.25 482.39 462.01 2663.64
0.6 2643.25 578.87 687.25 2534.88
0.7 2643.25 675.35 898.71 2419.90
0.8 2643.25 771.83 951.57 2463.51
0.9 2643.25 868.31 1255.54 2256.01

Wrap-up
One properly typed document submitted via the Hub

Submission: 11th November, 2019, 4 pm
Next week: Solution for coursework 2

Alfred Inc.’s Market Value of Debt
Market Value of Debt

Alfred Inc. is a publicly traded sporting goods company. The company has
$250M in book value of debt, reported interest expenses of $12.5M in the
most recent year and has an average maturity of 5 years for the debt. The
pre-tax cost of debt for the firm is currently 4%. What is your best
estimate of the market value of debt outstanding at the firm? (Assume
annual interest payments and a marginal tax rate of 40%.)

What is the market value of debt?

Sum of present values of interest expenses and bond principal
What kind of assumptions to make?
Interest expense will stay constant over the foreseeable future
Not unreasonable since no mentioning of new debt issuance
Use the annuity formula to value the the interest payments
(1 + g )T

C
PV = 1−
r −g (1 + r )T
C = $12.5M
r = 4%
g = 0%
T =5

The market value of interest expenses VIE is

12.5 1
VIE = × 1−
0.04 (1.04)5
The market value of the bond’s principal VB is

250
VB =
(1.04)5
Hence, the market value of debt VD is
VD = VIE + VB
= $261.12M

Jack’s Stores Operating Leases
Operating Leases
Jack’s Stores is a retail firm with no conventional debt. It does have
operating lease commitments of $12M each year for the nezt 8 years.
Jack’s Stores pre-tax cost of debt is 5%, its cost of capital is 9% and the
marginal tax rate is 40%. What is the debt value of operating leases?

Jack’s Stores Operating Leases
Using the annuity formula to price the present value of

operating leases
C = 12
r = 5%
g = 0%
T =8
Let the present value of operating leases be VOL

12 1
VOL = × 1−
0.05 (1.05)8
= $77.6M

Faraday Enterprises’ Cost of Capital
Cost of Capital (I)

Faraday Enterprises is a publicly traded company. It currently has 10M
shares trading at $ 12 per share and $150M in book value of equity. The
firm also has book value of debt of $75M and market value of debt of $
80M. The cost of equity for the company is 9%, the pre-tax cost of debt is
4% and the marginal tax rate is 40%. What is the cost of capital?

Computing the cost of capital by weighting the cost of debt and cost
of equity by market value weights
Step 1: Calculate market value weights of equity and debt
With market value of firm VM , market value of equity VE and market
value of debt VD ,
VM = 120 + 80 = $200M
VE 120
= = 60%
VM 200
VD 80
= = 40%
VM 200

Step 2: With tax rate t = 40%, calculate cost of capital rFaraday

by value-weighting cost of equity rE and cost of debt rD
VE VD
rFaraday = × rE + × (1 − t) × rD
VM VM
= 0.6 × 0.09 + 0.4 × (1 − 0.4) × 0.04
= 6.36%

Lester Inc.’s Cost of Capital

Lester Inc. has 5M shares outstanding, trading at $ 20 per share. The
company has one convertible bond, with a face value of $ 100M, a ten
year maturity and a coupon rate of 2%. The bond has a market value of $
120M. If the current cost of equity for the firm is 10%, the pre-tax cost of
debt is 5% and the marginal tax rate is 40%, what is the cost of capital for
the firm?

What is the market value of Lester Inc.?

Sum of market value of equity VE and market value of debt VD
But what is the market value of debt, i.e. the convertible
bond?
Decompose the convertible bond into a straight bond VB and the
market value of the option VO
The conversion option allows bondholders to convert debt into equity,
hence we have to calculate the market of diluted equity VDE
The market value of Lester Inc. VLester can be written as
VLester = V +V +VB
| E {z O}
Market value of diluted equity,VDE

Step 1: Calculate the market value of equity
VE = 20 × 5 = $100M
Step 2: Calculate the present value of bond using the annuity

formula

0.02 × 100 1 100
VB = × 1− 10
+ = $76.83M
0.05 (1.05) (1.05)10

Step 3: Backing out the market value of option
VO = VD − VB = 120 − 76.83 = $43.17M
Step 4: Calculate the weighted average cost of capital

143.17 76.83
rLester = × 0.1 + × (1 − 0.4) × 0.05
143.17 + 76.83 143.17 + 76.83
= 7.55%

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BS97318

MSc Finance and Accounting

Imperial College London

Plan for Today

1 Coursework 2: Guidelines and FAQ

Adrian Lam (Imperial College) Tutorial 4 November 6, 2019 1 / 37

File Names and Layout

Adrian Lam (Imperial College) Tutorial 4 November 6, 2019 2 / 37

What is the question we have in mind?

Adrian Lam (Imperial College) Tutorial 4 November 6, 2019 3 / 37

What information do we have?

What is the problem from a mathematical point of view?

Adrian Lam (Imperial College) Tutorial 4 November 6, 2019 4 / 37

Share Buyback: An Example

Lam and Li Inc.

Adrian Lam (Imperial College) Tutorial 4 November 6, 2019 5 / 37

Share Buyback: An Example

Lam and Li Inc.

What is the current cost of capital?

rE =rf + β × ERP = 4.5% + 1.1 × 4.0% = 8.9%

Adrian Lam (Imperial College) Tutorial 4 November 6, 2019 6 / 37

Share Buyback: An Example

Lam and Li Inc.

What is the new beta β 0 ?

Adrian Lam (Imperial College) Tutorial 4 November 6, 2019 7 / 37

Share Buyback: An Example

What is the new cost of equity rE0 ?

Adrian Lam (Imperial College) Tutorial 4 November 6, 2019 8 / 37

Share Buyback: An Example

What is the new weighted average cost of capital wC0 ?

Adrian Lam (Imperial College) Tutorial 4 November 6, 2019 9 / 37

Share Buyback: An Example

What about new level of equity E 0 ?

Simplifying, we can write rC0 as

Adrian Lam (Imperial College) Tutorial 4 November 6, 2019 10 / 37

Share Buyback: An Example

Combining equations (1) and (2), we can solve for E 0

2.82 + 0.089E 0 10.35 + 0.03E 0

Adrian Lam (Imperial College) Tutorial 4 November 6, 2019 11 / 37

Share Buyback: An Example

What is the new weighted average cost of capital?

∆EV $127.63M − 150M + 50M

Adrian Lam (Imperial College) Tutorial 4 November 6, 2019 12 / 37

Share Buyback: Approximate Solution

What is the current WACC?

rC = rE =rf + β × ERP = 4.5% + 1.1 × 4.0% = 8.9%

What is the new level of equity?

Adrian Lam (Imperial College) Tutorial 4 November 6, 2019 13 / 37

Share Buyback: Approximate Solution

What is the new return on equity?

What is the new WACC?

Adrian Lam (Imperial College) Tutorial 4 November 6, 2019 14 / 37

Share Buyback: Approximate Solution

What is the change in share price?

Adrian Lam (Imperial College) Tutorial 4 November 6, 2019 15 / 37

Optimal Debt Ratio

Senndynamics’ Optimal Debt Ratio

Adrian Lam (Imperial College) Tutorial 4 November 6, 2019 16 / 37

Optimal Debt Ratio

Debt Ratio Bond Rating Interest Rate on Debt

Adrian Lam (Imperial College) Tutorial 4 November 6, 2019 17 / 37

Optimal Debt Ratio

What is the optimal debt ratio?

Adrian Lam (Imperial College) Tutorial 4 November 6, 2019 18 / 37