M.Sc.

Finance 2003

in Glasgow Finance III: Tutorial One

ANSWERS
Options
Q1. The following data is taken from the Financial Times on Thursday February 1 st and gives Abbey
National’s share price and the prices of options written on the share with exercise prices of 1150
and 1200, maturing in April, July and October.

Abbey National Calls Puts

(1167) April July Oct April July Oct
X = 1150 71 109½ 126½ 65 91½ 106
X = 1200 48½ 86½ 104 94 119 133½

a Determine the intrinsic and time values of the various puts and calls with an exercise price
) of 1150.

Calls Puts
April July Oct April July Oct
Intrinsic Value 17 17 17 0 0 0
Time Value 54 92½ 109½ 65 91½ 106

b Contrast the breakdown of the prices into an intrinsic value component and a time value
) component for the calls with April and October maturity dates.

Fairly obviously “breakeven” : the longer the time to maturity the higher the time value
(given the interest factor and volatility factor)

c) Assume that the annual interest rate is 6 per cent provide and estimate of the minimum value
of an October call given that the current share price is 1167. What would this value be if the
interest rate had been 12 per cent rather than 6 per cent? Draw an illustrative diagram to
represent the set of minimum prices for different share prices if the rate of interest is 6 per
cent (assume 0.5 per cent per month).

i. 1
C t  S t  PV ( X )  1167  1150  66.52
1.045
ii. 1
Ct  S t  PV ( X )  1167  1150  111 .95
1.09
iii.
66.52

 X
1100.48 1150 1167

1
d Estimate the value of an April put with an exercise price of 1150 using the put-call parity
) proposition if the interest rate is 6 per cent per annum or 1 per cent for the two month
period.

P0  C t  PV ( X )  S t 2 months to go to April
1
 71  1150  1167  42.61
1.01

The difference to the quoted price may be the result of using the wrong interest rate or the
possible influence of an expected dividend that we have no information on.

e) Using the data provided draw illustrative diagrams for a straddle strangle, a covered call,
and a bull spread. Identify the key features in each diagram.

April Straddle April Strangle

1313.5
1286
1150 1150 1200
(-113.5)
(-136) 1036.5
1014

Covered Call Bull Spread

(April X = 1200)
Share
(1200 – 1167) + 48½ = 81.5

48½ 27.5
1150
1167 1200
-22.5 1200
Buy a call at 71
Sell call at 48.5
Net cost 22.5

2
Q2. The price of a share is 80p and over the next period it is anticipated that the price of the share
may increase or decrease by 10p. Estimate a price of a call with an exercise price of 85p if the
interest rate for the period is 2 per cent. Assume next that the returns on the share are more
volatile and the price can increase or decrease by 20p.

C MAX  C MIN 50 5 1

h   
S S
MAX MIN
90  70 20 4

1
 C 0  (25) S 0  .25(70)
1.02
1
 C 0  .25  80  .25  70 
1.02
C 0  2.843

C MAX  C MIN 15  0 15 3
h   
S S
MAX MIN
100  60 40 8
3 3 1
 C 0  80   60
8 8 1.02
C 0  7.941

Q3. It is usually assumed that only non-diversifiable risk is relevant for the pricing of assets in highly
competitive capital markets? Is this true of options?

Any source of price variation is relevant for the pricing options – therefore total risk and not such
systematic risk should be considered.

3
 M.Sc. Finance 2002

in Glasgow Finance III: Tutorial Two

ANSWERS
Rights Issues
Q1. Radiant plc is considering raising additional equity capital of £60 million through a rights issue.
The company has 90 million shares outstanding and its current share price is £2.50. One
possibility would be to set the subscription price at £2.00, giving a conventional discount of 20
per cent. To ensure that the company obtains the funds it requires the issue could be
underwritten. Alternatively, the company could make a deep discount issue, setting the
subscription price at £1.20.

Radiant Plc
P0 = £2.50 N0 = 90m V0  P0 N 0 = £225m

F = £60m Conventional discount = PSC = £2.50 (1 – 0.2) = £2.00

Deep discount = PSD = £2.50 (1 – 0.52) = £1.20

Terms: Conventional discount

F £60m
N C  C
  30m
PS £2.00

Deep discount
F £60m
N D  D
  50m
PS £1.20

For the conventional discount issue

30 m shares for 90m or 1 for 3 at £2.00

For the deep discount issue

50 m shares for 90m or 5 for 9 at £1.20

4
a Determine the theoretical ex-rights price and the value of the rights for the conventional and
) the deep discount issue.

Conventional Discount
 V0  F 
PXC 
N 0  N 0 


 £225m  £60m 
 90m  30m 

£285m
  £2.375
120m

 
V R C  PXC  PSC  £2.375  £2.00  37.5 p

Deep Discount
 V0  F 
PXD 
N 0  N D 


 £225m  £60m 
 90m  50m 

£285m
  £2.0357
140m

 
V R D  PXD  PSD  £2.0357  £1.20  83.57 p

b What will happen to the value of the right if the subscription price is set with a conventional
) discount, and the cum-rights share price falls to £2.20 during the subscription period?

Everytime the price of the share (cum-rights price) changes so does the expected ex-rights
price and the value of a right. Such price changes affect the basic value of the company  V  .

PX* 
V  F
0
*

 N 0  N 
where V0*  £2.20  90m  £198m


 £198m  £60m   £2.15
 90m  30m 

V  R   PX  PS  £2.15  £2.00  £0.15

5
 c) Demonstrate, using the two possible sets of terms, that in principle shareholders will be
indifferent to the level of subscription price set in a rights issue.

Consider an investor holding 9 shares and her reaction to first a conventional discount and
then to a deep discount issue.

Purchase Additional Shares

Conventional Discount Deep Discount

Initial Investment Initial Investment

9 shares at £2.50 = £22.50 9 shares at £2.50 = £22.50
Buy 3 more at £2.00 = £6.00 Buy 5 more at £1.20 = £6.00
Total investment = £28.50 Total investment = £28.50
Value of 12 shares at £2.375 = £28.50 Value of 14 shares at £2.0357 = £28.50
(the ex-rights price)
Change in wealth = 0 Change in wealth = 0

Sell Rights
Conventional Discount Deep Discount

Initial Investment Initial Investment

9 shares at £2.50 = £22.50 9 shares at £2.50 = £22.50
Sell 3 rights at 37.5p = -1.125 Sell 5 rights at 83.57p = -4.18
Remaining Investment = £21.375 Total investment = £18.32
Value of 9 shares at £2.375 = £21.375 Value of 9 shares at £2.0357 = £18.32
Change in wealth = 0 Change in wealth = 0

Q2. a Explain what is meant by the price-pressure hypothesis.

)

b The evidence suggests that the share prices falls on the announcement of a new issue. (This
) is a real fall in price rather than the mechanical adjustment to the terms of a rights issue.)
Should this evidence deter companies from making rights issues?

c) Consider the value of underwriting a rights issue.

6
 M.Sc. Finance 2002

in Glasgow Finance III: Tutorial Three

ANSWERS
Gearing and Capital Structure
Q1. Tartan plc has always followed a policy of avoiding any debt financing. But the company needs
to raise an additional £20m to finance a major project and is considering the issue of a
debentures at 10 per cent. Alternatively it could sell 10 million additional shares at the
prevailing market price of £2. This would increase the number of shares outstanding by 50 per
cent. Earnings following the investment in the new project are expected to reach £20m before
tax. One of the advantages of employing debt would be the tax savings associated with the
interest expense. The tax rate is 40 per cent. But it is also recognised that earnings could fall
below the expected level.

No of shares outstanding ( N 0 ) 20m

Proposed issue of shares ( N ) 10m
Price per share £2m
Additional Funding Required £20m

a Calculate the expected earnings per share for both financing possibilities.
)

Ungeared Geared
Expected profit before interest and tax £20m £20m
Interest (£20m x 0.10) - (2m)
Profit before tax £20m £18m
Tax (40 per cent) (8m) (7.2m)
Profit after tax 12m 10.8m
No of shares 30m 20m
Expected earnings per share 0.40 0.54

b Calculate the level of earnings at which earnings per share would be the same for both
) financing possibilities.

Let the level of earnings (profit) at which the expected earnings per share would be the same
for both financing options be X * .

X * 1  t c   X *  k i BG  1  t c 

N 0  N N0
X * 1  0.4   X *  0.10  £20m  1  .4 

30m 20m
Cancel the tax factor and cross multiply
20 X *  30 X *  60m
10 X *  60m
X *  6m

7
 Quick check:
Ungeared Geared
Expected profit before interest and tax £6m £6m
Interest - (2m)
Profit before tax £6m £4m
Tax (£2.4m) (£1.6m)
Profit after tax £3.6m £2.4m
No of shares 30m 20m
Expected earnings per share £0.12 £0.12

c) As the expected earnings per share is greater if debt financing is employed doe this imply
that the new project should be financed by debt?

In a word – no! The earnings per share for the geared option is riskier than that for the
ungeared option, and consequently are not directly comparable. Moreover, the earnings per
share figure is not as relevant as the value of the equity or the cost of capital in the
assessment of financing options. Lastly, the earnings per share figure for one year might be
misleading if we drop the convenient assumption that expected earnings are unchanged
indefinitely into the future – the perpetuity assumption.

Q2. A company’s expected earnings before corporate tax for the coming year is £10m and it is
anticipated that it will be able to maintain this level of earnings indefinitely into the future. The
company is financed entirely by equity but is considering the possibility of issuing debt of £20m
at an interest rate of 8 per cent to replace some of its equity.

a) In a world without taxes the all equity financed company is valued at £50m. Determine the
cost of equity capital and the weighted average cost of capital for the company if its capital
structure is reorganised to include debt of £20m. Use both the traditional and Modigliani-
Miller approaches.

Vu  £50m BG  £20m

Traditional Approach
( ke and ki are assumed to be constant over the relevant range.)

X £10m
where ke    0.20
SG £50m

SG B
WACC  ke  ki G
VG VG

30 20
 .20  .08
50 50

 0.152 (15.2%)
Modigliani Miller Approach
Basic proposition  VU  VG  S G  BG  £20m  £30m  £50m

8
 X  kiBG 10  1.6
ke    0.28
SG 30

BG 20
ke  kU   kU  ki   0.20   0.20  0.08
SG 30

SG B 30 20
WACC  ke  ki G  0.28  0.08  0.20
VG VG 50 50

b) Determine the value of the company for both the non-geared and geared capital structures if
the corporate tax rate is 40 per cent, and the required rate of return after corporate tax on
the all equity financed company is 15 per cent. There are no personal taxes. (Assume that
the Modiglianai-Miller model with corporate tax is valid.)

X 1  t c 
VU 
kU

1
 £10m1  0.4   £40m
0.15

VG  VU  t c BG  $40m  0.4  £20m  £48m

S G  VG  BG  £48m  £20m  £28m

c) Determine the equity cost of capital and the weighted average cost of capital using the
Modigliani-Miller model with taxes.

X  k i BG 1  t c  10m  1.6m 1  0.4 

ke    0.18  18.00%
SG 28m

BG
ke  kU   kU  k i 1  t c 
SG

20
 0.15   0.15  0.081  0.4   0.18
28
SG B
WACC  ke  k i 1  t c  G
VG VG

28 20
 0.18  0.081  0.4 
48 48

 0.105  0.02  0.125

X 1  t c  101  0.40
WACC    0.125
VG 48

9
 M.Sc. Finance 2002

in Glasgow Finance III: Tutorial Four

ANSWERS

Capital Structure and Cost of Capital

Q1. SAD plc is expected to record profits of £135 million before tax next year. The company has no
growth prospects and all its profits are paid out in the form of dividends. The company is finance
entirely by equity and the Finance Director is considering restructuring the company’s capital to
increase its expected earnings per share, and boost the company’s share price. It is proposed to
replace 30 million shares of the 90 million outstanding with the proceeds of an issue of debt at 6
per cent. The shares are currently trading at £5.00 and the issue of debt would be for £150
million. One perceived advantage of the debt issue is the tax saving to be made on the interest
payments, and the tax rate is 40 per cent.

X = £135m N0 = 90m ki = .06

P0 = £5.00 V0 = P0  N 0 = £5 x 90m = £450m
BG = £150 N1 = N 0  N = 60m N = 30m

a Determine the company’s cost of capital assuming it continues to be financed entirely by

) equity and comment briefly on the assumptions underlying your analysis.

X 1  t c  1351  0.4 
ku    0.18
Vu 450

Assumes that markets are perfectly competitive other than for recognition of the taxes
(corporate). The model assumes that the expected earnings are at the same level indefinitely
into the future, allowing the case of a perpetuity framework.

b Determine the value of the company following the restructuring, assuming that the proposed
) debt issue is free of bankruptcy risk.

Use the Modiglian-Miller with corporate tax:

VG  Vu  t c BG
 £450  0.4  £150m  £510

10
c) Determine the equity cost of capital and the weighted average cost of capital following the
restructuring.

X  k i BG  1  t c 
ke 
SG

S G  VG  BG  £510m  £150m  £360m

k i BG 
135  9 1  .4  0.21
360

BG
k e  k u   k u  k i  1  t c 
SG
150
 0.18   0.18  0.06 1  0.4   0.21
360

SG B
WACC  k 0  k e  k i 1  t c  G
VG VG
360 150
 0.21  0.061  0.4 
510 510

 0.1482  0.01059  0.1588

 B 
WACC  k u 1  t c G 
 VG 
 150 
 0.181  0.4   0.1588
 510 

X 1  t c  1351  0.4
WACC  k 0    0.1588
VG 510

11
d Assume that the Miller (Debt and Taxes) model holds, there is no risk of bankruptcy, and the
) capital gains tax is 20 per cent, profits tax is 40 per cent, the personal tax rate on interest
income is 30 per cent. Determine the value of SAD plc using this model.

Use Miller (1977)

VG  Vu  BG t *
where
 1  t c  1  t g  
t *  1 
 1  t p  
 1  .4 1  .2  
 1   0.3143
 1  .3 

VG  450  150  0.3143

 £450  £49.142  £497.142
e) Demonstrate, using the following diagram

i. the impact of the introduction of a more progressive schedule for the taxation of
interest income
ii. a reduction in the rate of corporate tax
iii. the elimination of the tax exempt status of all institutions

i. Adjusted Interest Rate

D2
D1
k ** S
i

More progressive tax scheme

k e*  k i*

Aggregate debt
AD1 AD0

More progressive tax scheme implies that at each level of income individuals have to pay
more tax, ie. for a level of given income t p is higher. This implies that higher interest rates
are required to compensate investors in a given income bracket for their higher tax payments
so as to make debt as attractive as equity investments.

12
ii. Adjusted Interest Rate
1
D k i**  k e*
S 1  t c 
k i**
1
k i**  k e*
1  t c 

k e*  k i*

Aggregate debt
AD1 AD0

As the tax advantage of debt falls with reductions in the corporate tax rate so will the
incentive to issue debt, and the level of debt will fall. The before tax interest rate will also
fall.

iii Adjusted Interest Rate

D2
D1
S

Aggregate debt
AD1 AD0

As all investors will have to pay tax there will be no horizontal section to the demand
schedule. The elimination of a class of investors that found debt and equity equally attractive
at the same (before tax) rate of return will result in less debt being held in equilibrium.

13
Q2. a If the corporate tax rate is 40 per cent, the personal tax rate on interest income is 20 per
) cent, and the effective capital gains tax is 10 per cent, determine the tax advantage of
employing debt.

VG  VU  t * BG

 1  t c  1  t g  
 VU  BG 1 
 1  t p  

Before tax advantage can be expressed as a proportion of debt

 1  t c  1  t g    1  0.4 1  0.1 
BG 1    BG 1 
 1  t p    1  0.2 


 BG 1  0.675

 0.325BG

b Given t c  .40 and t g  .10 determine the value of t p that is necessary to eliminate the tax
) advantage of debt.

No tax advantage when

 1  t c  1  t g  
1  0
 1 tp 

1  t c  1  t g 
1
1  t  p

1  0.41  0.1 1
1  t  p

1  0.4 1  0.1  1  t p 
1  1  0.4  1  0.1  t p
1  0.54  t p
0.46  t p

14
Q3. If the cost of debt and equity in equilibrium is 15 per cent on a risk adjusted basis, interest is a
tax deductible expense and the corporate tax rate is 25 per cent determine the interest rate level
at which the company will be indifferent between issuing debt and equity.

 1  t c  1  t g    1  0.4 1  0.05 
t *  1 
 1  t p    1  1  0.25   0.24
let BG  0.3 VG

 B 
k 0  k u 1  t * G 
 VG 

 0.3 
 0.201  .24 
 1.0 

 0.1856

Q4. Determine the cost of capital (ie. the rate of return required after allowing for corporate tax) for
an investment if the required rate of return on an ungeared company is 20 per cent and the
corporate tax rate is 40 per cent, personal tax rate is 25 per cent, capital gain rate is 5 per cent
and the firm employs 30 per cent debt in its financing.

Q5. What factors might be important in the debt-equity decision that appear to be ignored in the
theoretical literature?

a) the history of the company and its standing in the market

b) the nature of the company’s assets – general purpose and easily sold, or highly specific and
only of value to the company (low resale value)
c) managerial expectations and the reluctant to issue equity if it is believed (with or without
good reason) that the share price will rise.
etc.

Q6. a “If bankruptcy is costless the risk of bankruptcy produced by gearing should not deter a
) company from issuing debt.” Explain

b Differentiate between the nature of bankruptcy costs on an ex ante and ex post basis. (Who
) bears the costs on an ex ante and ex post basis?).

15