General Assumptions Policy No Debt Constant Debt Constant D/E

Operating Margin 20% Book Value Firm A Firm B Firm C

Interest Rate (Rd) 5% Debt - 500 500
Taxes 40% Equity 1,000 500 500
1,000 1,000 1,000

Income St. Firm A Firm B Firm C

EBIT 200 200 200
Less: Interest - 25 25
PBT 200 175 175
Less: Taxes 80 70 70
PAT/ Dividend 120 105 105

Return on Asset (Ra) 12.00% 12.00% 12.00% (Return on Asset is same i

Approach 1 - Ra
Unlevered Firm Value 1,000 1,000 1,000 (Unlevered Firm Value is s
Value of ITS - 200 83
Total Firm Value 1,000 1,200 1,083

Market Value
Debt - 500 500
Equity 1,000 700 583 Total Firm Value - Debt Va

Approach 2 - WACC
Return on Equity (Re) 12.00% 15.00% 18.00% Dividend/Equity Market V
WACC 12.00% 10.00% 11.08% (Re*E/V) + (Rd*(1-t)*D/V)
FCFF 120 120 120 EBIT (1-t)
Total Firm Value 1,000 1,200 1,083 FCFF/WACC
(Return on Asset is same irrespective of Capital Structure)

(Unlevered Firm Value is same irrespective of Capital Structure)

Total Firm Value - Debt Value

Dividend/Equity Market Value

(Re*E/V) + (Rd*(1-t)*D/V)

FCFF/WACC
 Note - Question mentions constant Debt-Equity R
O/S Shares 10,000,000 a)
TRU Equity Beta 1.17
FCF1 15,000,000 TRU Cost of Equity 12.02%
Growth Rate 4%
b)
UAL TRU TRU Cost of Debt 5.00%
Equity Beta 1.50 WACC 9.94%
Debt Beta 0.30 -
D/E Ratio 1.00 0.30 c)
D/V 0.50 0.23 Value of levered firm 252,590,674
E/V 0.50 0.77
d)
Tax Rate 40% Value of Equity 194,300,518
Rf 5% Equity Share Price 19.43
Rm 11%
(Rm-Rf) 6%

Asset Beta 0.90 0.90

ntions constant Debt-Equity Ratio for TRU
Particulars Sprint Nextel
Price 25 30
O/S Shares (mn) 12 8 Alternate Scenario 1 - All Cash Deal instea
Equity Value 300 240 Sprint pays Rs. 35 per share to Nextel shar
Swap Ratio 1.4 Sprint share per Nextel Share Price 35
Synergy (mn) 80 Wealth of SH
Shareholders Pre-Deal
a) Sprint 300
Sprint Value Post Deal 620.00 Nextel 240
Old Shares - Sprint 12.00
New Shares - Nextel 11.20 (New Sprint shares issued to Nextel Shareholders)
Total O/S Shares 23.20
Sprint New Price 26.72 Alternate Scenario 2 - Part Cash and Part
Wealth of SH Sprint pays Rs. 5 per share and offers 1.2 s
Shareholders Pre-Deal Post-Deal SH Gain Price 5
Sprint 300 320.69 20.69 Wealth of SH
Nextel 240 299.31 59.31 Shareholders Pre-Deal
Sprint 300
b) Nextel 240
Sprint Share Price 26.72
Nextel Share Price 37.41

c)
Take synergy as 'x', New Sprint Share Price = (300+240+x)/23.20
Sprint's Old Shares Value after merger = (300+240+x)*12/23.20 which should be equal to old value i.e. 300 in order to breakev
Minimum Synergy (x) 40
nario 1 - All Cash Deal instead of All Stock Deal
. 35 per share to Nextel shareholders in exchange of every Nextel share
per Nextel Share
Wealth of SH
Post-Deal SH Gain
340 40
280 40

nario 2 - Part Cash and Part Stock Deal instead of All Stock Deal
. 5 per share and offers 1.2 shares of Sprint to Nextel shareholders for every Nextel share
per Nextel Share Swap Ratio 1.2 Sprint share per Nextel Share
Wealth of SH
Post-Deal SH Gain Sprint Value Post Deal 580.00
322.22 22.22 Old Shares - Sprint 12.00
297.78 57.78 New Shares - Nextel 9.60
Total Shares 21.60
Sprint New Price 26.85

e i.e. 300 in order to breakeven

Market Value Note - Question mentions constant Debt-Equity Ratio
Equity 100 mn
Debt 40 mn
Levered Firm Value 140 mn

D/E Ratio 0.40

D/V Ratio 0.29
E/V Ratio 0.71
Cost of Debt (Rd) 7.50%
Tax Rate 35%

1)
FCF1 (mn) 7
Growth Rate 3%
Take WACC as 'x'. Thus, 180 = 7/(x-3%)
WACC 8.00%

2)
WACC = Rd*(1-t)*D/V + Re*E/V
Rd*(1-t)*D/V 1.39%
Re*E/V 6.61%
Cost of Equity (Re) 9.25%
Return on Asset (Ra) 8.75%
Unlevered Firm Value 121.74
PV of ITS 18.26 PV (ITS) = Value of Levered Firm - Value of Unlevered Firm
Alternate Method
PV of ITS 18.26 PV (ITS) = ITS/(Ra-g)
Equity Ratio
Base Case Scenario (as given in question) Alternate Scenario 1 - If concess
Life 30 years Life
Investment 5,000 crores Investment
Tax Rate 30% Tax Rate

Debt Type
Particulars Market Concessional Total Particulars
Amount (cr) 2,000 500 2,500 Amount (cr)
Interest Rate 12% 0% Interest Rate
Maturity (yrs) 15 10 Maturity (yrs)

1) 1)
Debt borrowing of 2,000 crore will lead to savings as Interest Tax Shield
Since debt is constant, PV of ITS will be discounted at Rd ITS for Year 1
PV (ITS) 490.38 PV (ITS)
Ans - The NPV will increase by Rs. 490.48 crores Ans - The NPV will increase by Rs

2) 2)
PV of ITS will be zero since no interest is being paid on Rs. 500 crore but PV of
Subsidy will contribute to increase in NPV
Loan Received 500.00 (Amount received in cash) Loan Received
PV of Loan 223.19 (Market Value of Loan considering market rate) PV of Loan
PV of Subsidy 276.81 (Benefit on account of subsidized loan) PV of Subsidy
Note - Post-tax rate will be used for discounting i.e. 8.40% {12%*(1-30%)}
because we would have received ITS benefit, had we borrowed @12%

3) 3)
Unlevered NPV -400.00 cr Unlevered NPV
Adjusted NPV 367.19 cr Adjusted NPV
rnate Scenario 1 - If concessional debt rate was 8% (not 0%) Alternate Scenario 2 - If debt was perpetual and concess
30 years Life 30 years
5,000 crores Investment 5,000 crores
30% Tax Rate 30%

Debt Type Debt Type

Market Concessional Total Particulars Market Concessional
2,000 500 2,500 Amount (cr) 2,000 500
12% 8% Interest Rate 12% 8%
15 10 Maturity (yrs) Perpetual Perpetual

1)
Market Concessional Total Market Concessional
72 12 ITS for Year 1 72 12
490.38 67.80 558.18 PV (ITS) 600.00 100.00
- The NPV will increase by Rs. 558.18 crores Ans - The NPV will increase by Rs. 700 crores

2)

500.00 (Amount received in cash) Loan Received 500.00 (Amount received in cash)
407.73 (Market Value of Loan considering market rate) PV of Loan 333.33 (Market Value of Loan conside
92.27 (Benefit on account of subsidized loan) PV of Subsidy 166.67 (Benefit on account of subsidiz

3)
-400.00 cr Unlevered NPV -400.00 cr
250.45 cr Adjusted NPV 466.67 cr
was perpetual and concessional debt rate was 8%

Total
2,500

Total

700.00
Rs. 700 crores

mount received in cash)

arket Value of Loan considering market rate)
enefit on account of subsidized loan)
Investment 10,000,000
FCF1 750,000
Growth Rate 4%

D/E Ratio 0.40

D/V Ratio 0.29
E/V Ratio 0.71

Re 11.30%
Rd 5.00%
Tax Rate 35%

WACC 9.00%
PV of CF 15,000,000 For a levered firm = FCF1/(WACC-g)
NPV 5,000,000

Ra 9.50%
PV of CF 13,636,364 For an unlevered firm = FCF1/(Ra-g)
PV of ITS 1,363,636
Competitor Equity Beta D/V Ratio E/V Ratio Asset Beta
UF 0.80 0.30 0.70 0.56
GE 1.60 0.20 0.80 1.28
AC 1.20 0.40 0.60 0.72

Amalgamated Products
Divisions Weights Asset Beta Product
Food 50% 0.56 0.28
Electronics 30% 1.28 0.38
Chemicals 20% 0.72 0.14
Amalgamated Asset Beta 0.81

Amalgamated D/V Ratio 0.40

Amalgamated E/V Ratio 0.60

Amalgamated Equity Beta 1.35

D/V 0.30
E/V 0.70

Rd 8%
Re 12%
Tax 35%

Future D/V 0.60

Future E/V 0.40
Future D/E 1.5

1)
Ra 10.80%

2)
Re considering increased D/V Ratio (Ra will remain constant)
New Re 15.00%

3)
Old WACC 9.96%
New WACC 9.12%
 Note - Question mentions constant Debt
Share Price 50 1)
O/S Shares 2.5 bn Re 7.00%
Tax Rate 35%
2)
D/E Ratio 0.25 WACC 6.15%
D/V Ratio 0.20
E/V Ratio 0.80 1) Continued
Ra 6.44%
Equity Beta 0.50 Ra will remain the same irrespective of share repurchase
Rd 4.20% New Rd 4.50%
Rf 4.00% New D/E 0.67
Rm 10.00% New Re 7.73%
Rm-Rf 6.00%
2) Continued
New D/V 0.40
New E/V 0.60
New WACC 5.81%
estion mentions constant Debt-Equity Ratio

1) Continued
Alternate Method
Old Debt Beta 0.03
Asset Beta 0.41
New Debt Beta 0.08
New Equity Beta 0.62
New Re 7.73%
Ra 15% (Return of unlevered firm)
Tax Rate 35%
After Repurchase
D/E Ratio 1.00
D/V Ratio 0.50
E/V Ratio 0.50
Rd 10%

Even after repurchase, Ra will remain the same

Re 20.00%
WACC 13.25%
Firm Equity Beta Retail Weight Non Retail Business
Neighborhood 1.60 60% Real Estate
Lifestyle 1.20 75% Pharma
Greens 1.30 65% FS

Important Note
Before solving this question, always remember -
1) Equity Beta of any company is a weighted average of equity beta of its constituent businesses
2) For an unlevered firm, Equity Beta = Asset Beta
3) Asset beta is different for different businesses for e.g. Asset beta (or Return on Asset) of real estate business is not the same

Weightage Asset Beta

Firm Company Beta Retail Non-Retail Retail Non-Retail
Neighborhood 1.60 60% 40% 1.93 1.10
Lifestyle 1.20 75% 25% 1.42 0.55
Greens 1.30 65% 35% 1.60 0.75

Average Retail Beta 1.65 (Based on simple average - Right)

Average Retail Beta 1.63 (Based on weighed average - Wrong)
Note
1) Use simple avergae beta in this case since markets value of business is not given for each comparable firm. Green's retail bu
tate business is not the same as pharma business

rage - Right)
verage - Wrong)

parable firm. Green's retail business may be larger than Lifestyle's retail business in absolute terms.