Capital Structure

Self Correction Problems

Self Correction Problem 1

b)
Q Y
NOI 360,000 NOI 360,000
Ko .18 Ko .18

VF 2000000 VF 2000000

VD 1000000 VD 400000

VE 1000000 VE 1600000

NOI 360,000 NOI 360000

-Interest 1000000 * .13 130000 -Interest 400000 * .13 52000

E available to CS holders 230000 E available to CS holders 308000

Ke ( Ecs / VE) .23 Ke ( Ecs / VE) .1925

• If we own 2 percent of Q firms, it means 2 percent of 230,000 would be our dollar return
= 230000* .02 = 4600

Self Correction Problem 2

EBIT = 3000000$, Tax rate = 40 percent, I = 14 percent, Ke = .18

Value of Firm (if unlevered)

EBIT = 3000000
-Interest = 0
---------------
E available to CS = 3000000
Tax (40 %) = 1200000
--------------
Earnings after tax = 1800000
Ke = .18
Ve = 10,000,000
Vd = 0
Vf = 10,000,000

Value of Firm (with 4 million in debt)

VL = VUL + PV of tax shield benefit - PV of Bankruptcy and Agency Cost

VL = VUL + (t)(debt) - PV of Bankruptcy and Agency Cost
VL = 10,000,000 + (.40)(4000000) - 0
VL = 10,000,000 + 1600000
VL = 11,600,000

Value of Firm (with 7 million in debt)

VL = VUL + PV of tax shield benefit - PV of Bankruptcy and Agency Cost

VL = VUL + (t)(debt) - PV of Bankruptcy and Agency Cost
VL = 10,000,000 + (.40)(7000000) - 0
VL = 10,000,000 + 2800000
VL = 12,800,000
Self Correction 3
VUL = 15 million, tax rate = .20

VL = VUL + PV of tax shield benefit - PV of Bankruptcy and Agency Cost

VL = 15 + PV of tax shield benefit - PV of Bankruptcy and Agency Cost

(1) (2) (3) (4) (5)= 1+3- 4

VUL Level of PV of Tax shield benefit PV of Bank.
Debt (Debt)(tax rate) and agency cost VL
15 0 0 0 15
15 5 1 0 16
15 10 2 .6 16.4
15 15 3 1.2 16.8
15 20 4 2 17
15 25 5 3.2 16.8
15 30 6 5 16

Optimum debt level = 20 million

Because firm value is maximum at 20 million debt

ABC Company is considering the replacement of old machine that is 3 three years old with a

new, more efficient machine. The two old machines could be sold currently for a total of $75,000

in the secondary market, but they would have a zero final salvage value if held to the end of their

remaining useful life. Their original depreciable basis totalled $320,000. They have a depreciated

tax book value of $86,400, and a remaining useful life of eight years. MACRS depreciation is

used on these machines, and they are five-year property class assets. The new machine can be

purchased and installed for $500,000. It has a useful life of eight years, at the end of which a

salvage value of $70,000 is expected. The machine falls into the five-year property class for
accelerated cost recovery (depreciation) purposes. Owing to its greater efficiency, the new

machine is expected to result in incremental annual operating savings of $170,000 (10 percent

inflation in cash flows is expected). The company’s corporate tax rate is 40 percent, and if a loss

occurs in any year on the project, it is assumed that the company can offset the loss against other

company income.

Following additional information is provided:

• Annual maintenance cost on old machine is 3000$ whereas annual maintenance cost on

new machine is expected to be 4000$ for first year which may increase by 500$ every
year.

• New machine may require engine overhaul in year 5 which my cost 10,000$ every year.

• The cost of defects due to old machine were 500$ per year whereas the cost of defects

using new machine would be 500$ for first year, 1000$ for the second year and an

increase of 500$ every year son one till year 8.

• Due to replacement, following additional costs are required:

• Additional cash holdings = 8000 $

• Additional investment in inventory = 4000 $

• Concrete foundation for new machine = 1000$

• Training of new machine operator = 500 $

• Electricity cost may reduce by 800 units per year where per unit electricity cost is 3$ per

unit. However, this cost saving will decrease by 100 units per year.

The company has decided to finance this project by borrowing 30 percent of funds required at 12
percent. Likewise, 30 percent of funds required are raised by issuing preference shares at 13

percent. Remaining funds would b acquired by issuing common stock. The 6 months Treasury

bill rate is 10 percent and market required rate of return is 18 percent. The beta for the ABC

company stock is 1.2; you are required to estimate the incremental net cash flows and decide the

acceptance/rejection of this project by applying relevant capital budgeting techniques.

• Cash Flows

• Capital Budgeting Techniques

• WACC (Weighted Average Cost of Capital)

• Valuation of Securities

• CAPM (Capital Asset Pricing Model)

• MACRS

Sources of Finance

• Debt
• Common Stock
• Preferred Stock

Balance Sheet
Assets Amount Liab + Equ Amount
 Current Assets Current Liabilities

Long Term Debt

Fixed Assets Debt

O.Equity

Working Capital = Current Assets

Net Working Capital = Current Assets – Current Liabilities

Suppose Company A = 2- 1 = 1

Company B = 1 -1 = 0

Among these two company A seems more liquid because A can pay his current debts
more easily as compared to B. It means, more currents more liquidity

However, firm B may have higher profitability due to less funds engaged in current assets
as compared to Firm A

Working capital and Liquidly = Positive relationship

Working capital and Profitability = inverse relationship

Maturity Matching Approach = Financing assets with same maturity of financing sources

Temporary Working Capital: Investment in current assets over and above the permanent
 working capital

Permanent Working Capital: Minimum investment in working capital irrespective of any

business cycles/fluctuations

MACRS (Modified Accelerated Cost Recovery System)

• Half Year Convention

• Double Declining Balance Method

5 Years MACRS Rates

100/5 = 20 % * 2 = 40 %

Years MACRS Straight Line

1 100*40/100 =40% * 6/12 = 20 % 100/5 = 20 % * 6/12 = 10 % 20 %
2 80 * 40/100 = 32 % 80 / 4.5 = 17.78 32 %
3 80 -32 = 48 * 40 /100 = 19.2 % 48 / 3.5 = 13.71 19.2 %
4 48 -19.2 = 28.8 * 40 / 100 = 11.52 % 28.8 / 2.5 = 11.52 % 11.52%
5 11.52%
6 5.76 %

7 Years MACRS Rates

Years MACRS Straight Line

1
2
3
4
5
6
7
8

• 500,000 * 20 / 100 =
• 500,000 * 32/ 100 =
• 500,000* 19.2 / 100 =
• 500,000 * 11.52 /100 =
• 500,000 * 11.52 /100 =
• 500,000 * 5.76 /100 =

Old Machine

3 years old, current market price = 75,000 $, Book Value = 86,400, Original cost =
320,000 $, remaining useful life = 8 years, 5 years MACRS property class

New Machine

Cost = 500,000, useful life = 8 years, salvage value = $70,000, 5 years property
class

• Cost saving due to new machine = 170,000 $ ( 10 percent inflation every

year)
• Tax rate = 40 %
Additional Information:
 • Maintenance cost on old machine 3000 and new machine 4000 with 500
increase every year
• Engine repair 5th year onwards 10,000 $
• Cost of defects: old 500 $ every year, new 500 with increase of 500 every year

• Due to replacement, following additional costs are required:

• Additional cash holdings = 8000 $

• Additional investment in inventory = 4000 $

• Concrete foundation for new machine = 1000$

• Training of new machine operator = 500 $

• Electricity cost saving

Initial Cash Outflow

New machine cost = 500,000
• Old machine sale price = 75,000
---------------
= 425,000
• Tax benefit on Loss 11400 * 40/100 = 4560
---------------
= 420,440
• Additional investment in working cap = 12,000
• Concrete foundation = 1000
• Training of machine operator = 500
Initial Cash Outflow = 433940 $
0 1 2 3 4 5 6 7 8
Initial CO (433940)
Savings 170,000 187000 205700 226270 248897 273787 301165 331282

Inc. main (1000) (1500) (2000) (2500) (3000) (3500) (4000) (4500)
cost

Engine - - - - (10000) (10000) (10000) (10000)

Repair

Inc Cost
of defects - (500) (1000) (1500) (2000) (2500) (3000) (3500)

Elec. cost 2400 2100 1800 1500 1200 900 600 300
saving

Dep (old) (36864) (36864) (18432)

Dep (new) (100200) (160320) (96192) (57716) (57716) (28856)

Inc. dept (63336) (123456) (77760) (57716) (57716) (28856)

(433940) 103264 63644 126740 166054 177381 229831 284765 313582

Tax 40 % (41456) (25458) (50696) (66422) (70952) (91932) (113906) (125433)

+Inc. Dep 63336 123456 77760 57716 57716 28856

+Salvage 42000

+ inv in
working 12000
capital

Net CF (433940) 125144 161642 153804 157348 164145 166755 170859 242149

Net Cash Flows

0 (433940) (433940)
1 125144/ (1+.1390)1 109872

2 161642 / (1+.1390)2 = 124597

 3 153804 / (1+.1390)3 = 104086
4 157348/ (1+.1390)4 = 93490
5 164145/ (1+.1390)5 = 85627
6 166755/ (1+.1390)6 = 76372
7 170859 / (1+.1390)7 = 68702
8 242149 / (1+.1390)8 = 85486
Total PV of Cash inflows 513764

Capital Budgeting
The process of identifying, analyzing and selecting investment projects whose cash flows extend
beyond one year

Capital Budgeting Techniques/Tools

• Net Present Value

NPV = PV of cash inflows – PV of cash outflows

NPV = 513764 – 433940

NPV = 79820

Acceptance criterion: + --------------can be accepted

• Profitability Index

Profitability index = PV of Cash inflows / PV of Cash outflows

Profitability index = 513764 / 433940

Profitability Index = 1.18
 Acceptance Criterion: 1 or more ----------------------- Accept

• Payback Period

Number of years required to recover initial cash outflow

13.9 Percent
0 (433940) (433940)
1 125144/ (1+.1390)1 109872 324068

2 161642 / (1+.1390)2 = 124597 199471

3 153804 / (1+.1390)3 = 104086 95385
4 157348/ (1+.1390)4 = 93490 1895
5 164145/ (1+.1390)5 = 85627
6 166755/ (1+.1390)6 = 76372
7 170859 / (1+.1390)7 = 68702
8 242149 / (1+.1390)8 = 85486
Total PV of Cash inflows 513764

4 years and 1895/85627 = .0221

4.0221 Years Payback period

• Internal Rate of Return (IRR)

2 = 3
 2 (1 + IRR) = 3
2 (1 + .5) = 3
3 / (1+IRR ) =
3 / (1+.50 ) = 2
Cash inflows / ( 1 + IRR ) = 2 = Outflow
IRR is the rate at which PV of cash inflows is equal to the PV of cash outflows
IRR is the rate at which NPV becomes zero

Acceptance Criterion: IRR > WACC

30 percent 35 percent
1 125144/ (1+.30)1 96265 125144/ (1+.35)1 92699

2 161642 / (1+.30)2 = 95646 161642 / (1+.35)2 = 88692

3 153804 / (1+.30)3 = 70006 153804 / (1+.35)3 = 62512
4 157348/ (1+.30)4 = 55092 157348/ (1+.35)4 = 47372
5 164145/ (1+.30)5 = 44209 164145/ (1+.35)5 = 36606
6 166755/ (1+.30)6 = 34547 166755/ (1+.35)6 = 27547
7 170859 / (1+.30)7 = 27229 170859 / (1+.35)7 = 20907
8 242149 / (1+.30)8 = 29684 242149 / (1+.35)8 = 21948
PV of Cash inflows 398282
452678
PV of Cash Outflows (433940) (433940)
NPV 18738 (35657)

= iL + [(Ih –IL) (NPVL – NPV IRR)] / ((NPVL – NPVH)

= .30 + [(.35 –.30) (18738 – 0)] / ((18738 + 35657 )
= .30 + (.05) (18738) / (18738 + 35657 )
IRR =.3172 or 31.72 percent

Sources of Finance

Debt
 wd = .30
kd = 12 percent

Preferred Stock
wp = .30
kp = 13 percent

Common Stock
we = .40
ke = .196 or 19.6 percent

T.Bills / Risk Free Rate = .10 or 10 percent

Market rate of return = .18 or 18 percent

Beta = 1.2

Ke = Rf + b (Rm – Rf)
Ke = .10 + 1.2 (.18 – .10)
Ke = .196 or 19.6 percent

Weighted Average Cost of Capital

WACC = [(We) (Ke) + (Wp) (Kp) + (Wd) (Kd) (1-t)]

WACC = [(.40) (.196) + (.30) (.13) + (.30) (.12) (1-.40)]
WACC = .139 or 13.9 percent

Market
Mechanisms and means/procedures through which trading can take place.
Capital Market
Market where long term securities are traded
Primary Market
Where new securities are bought and sold
Secondary Market
Where already issued securities are traded.
Long Term Securities
• Preferred Stock
• Common Stock
• Bonds

Preferred Stock

Hybrid Security: Debt and equity features

Priority in dividend payment/ claims
Generally dividend is fixed/predetermined/ no voting right

• Cumulative Preferred Stock or Non-cumulative preferred stock

• With Call Option or Without Call Option
• Convertible or non convertible
• Participating or non-participating

Stock that normally provides a fixed dividend and whose payments are given priority over
common stock holders.
a. Cumulative or Non-Cumulative
• Cumulative Preferred stock entails a requirement that all cumulative unpaid
dividends on the preferred stock be paid before a dividend may be paid on the
common stock.
b. Convertible or Non-Convertible
• A preferred stock that is convertible into a specified number of shares of common
stock at the option of the holder.
c. With Call Option or Without Call Option
• With call option provision means that corporation at any time can call back these
preference shares and retire the issue.
d. Participating or Non-Participating
• Preferred stock where the holder is allowed to participate in increasing dividends
if the common stockholders receive increasing dividends.
For example:
Suppose that a 6 percent preferred issue ($100 par value) was participating preferred stock, so
that the holders were entitled to share equally in any common stock dividends in excess of $6 a
share. If the common stock dividend is $7, the preferred stockholders will receive $1 in extra
dividends for each share of stock owned.

Voting Rights (in Special Situations)

Arrearages on four quarterly dividend payments might constitute such a default. Under such
circumstances, preferred stockholders as a class would be entitled to elect a specific number of
directors. Usually, the number of directors is rather small in relation to the total.

Common Stock
IPO (Initial Public Offering): first issue of a new company
Seasoned Equity/offering: subsequent issuance of shares

Supported a new firm “A” is incorporated and issued 5,000 shares (IPO)
After some time 2,000 more shares were issued (seasoned equity)
After some time 1,000 more shares were issued (seasoned equity)

Full Subscription
Firm “A” wants to offer 5000 shares and applications/subscription for 5000 shares is received
Over Subscription
Firm “A” wants to offer 5000 shares and applications/subscription for 7000 shares is received
• First come first served
• Balloting
 • Green Shoe Option
• Pro-rata basis
Under subscription
Firm “A” wants to offer 5000 shares and applications/subscription for 4000 shares is received

Unsold shares will be sold to underwriter (commercial bank, investment bank or any other
financial institution) against some premium
Underwriter Syndicate: Group of underwriters

• Sale shares to underwriter on wholesale basis and underwriter will sale these share to the
market in retail
• Risk Transfer
• Expertise, skills

• Company will sale shares and responsibility of unsold shares will lie on underwriter
• Risk Transfer

• Best Efforts Selling: Underwriter will put his best efforts to sale shares, however, will not
assume the responsibility of unsold shares
• Expertise

• None or all which means if all shares are sold, whole issue will be
considered as cancelled

Appointment of Underwriter
• Competitive Bid

Appointment of underwriter through bids

Suppose,
 Firm A bids for Rs. 8 per share
Firm B bids for Rs. 9 per share
Firm C bids for Rs. 7 per share

• Negotiated Offering

Appointment of underwriter though negotiation

Agency Relationship: Principal agent relationship, shareholders management relationship

Agency Conflict: conflict of interest between shareholders and management

Principal-Principal Conflict: Conflict of interest among shareholders such as conflict of

interest between institutional shareholders and individual shareholders

Principal-creditor conflict: Conflict of interest between shareholders and creditors

Board of Directors: To protect the interests of all stakeholders’ particularly individual

shareholders

Owners/ Principal Shareholders

Board of Directors
 CEO

Management/Agent CFO

Management Team/Staff

Board of Directors

• Executive Directors

An employee/Executive of the company working also as board member such as

CEO/CFO

• Non-Executive Directors

Not an employee of the company and working only as board member

• Representative Non Executive Directors

Representative of any stakeholders such as creditors, government or institutional
investors etc
• Non-Representative Non-Executive Directors/Independent NED

Hired on the basis of their knowledge, experience, qualification and skills

Sources of Finance
Debt
Equity
Retained Earnings/By forgoing Dividends

Substitution Hypothesis: Dividends substitutes governance

mechanisms/monitoring

Outcome Hypothesis: Dividend payout is the outcome of governance mechanism

Borrowing Sources

• Bank/Financial Institution (Either short term or long term)

• Financing by payables (Short term)
• Public Borrowing by issuing securities (Either Short term or long term)
• Retained Earnings/ By forgoing dividends

• Commercial Paper (Short Term)

Maturity less than one year, normally 270 days , issued by corporation

Marketability of these securities depends upon the credit rating of issuing

 corporation

Different credit rating agencies such as PACRA in Pakistan, Moodies and

S &P internationally rates different companies on the basis of their cash
flows/credit standings

• Treasury Bills (Short Term)

Issued by government, auction sale, discount, risk free, 7 weeks, 14
weeks, 26 weeks etc

Bonds

Long Term borrowing by issuing debt securities

Different credit rating agencies such as PACRA in Pakistan, Moodies and

S &P internationally rates different companies on the basis of their cash
flows/credit standings

• Corporate Bonds
• Treasury Bonds (Directly issued by treasury department)
• Federal Govt. Bonds (Issued by any federal government backed
institution)
• Municipal Bonds

• Treasury Bonds
(Safest credit risk securities, normally maturity more than 10 years, securities issued by treasury
for less than 10 years and more than 1 year are termed as treasury notes)
• Federal Agency Securities
(Issued by federal government sponsored agencies)
 • Municipal Securities
(Securities issued by municipal governments, states or provincial governments)
• Corporate Bonds
(Long term debt securities issued by corporations)

Trustee: legal representative of bondholders

Indenture: Terms conditions, legal contract between bondholders and issuing firm
Debenture: Unsecured bond
Asset Backed Securities: securities sold against some collateral
Junk Bonds: High risk high return bonds, low credit rating
`Serial Bonds: mature in series, for example every year company will pay principal amount
along with interest.

Going Concern Value

The amount a firm could be sold for as a continuing operating business.
Liquidation Value
The amount of money that could be realized if an asset or a group of assets (e.g., a firm) is sold
separately from its operating organization
Book Value
The accounting value; asset cost minus accumulated depreciation
Market Value
The value at which asset trades
Intrinsic Value
The price a security “ought to have” based on all factors bearing on valuation

If market value is greater than intrinsic value = Overvalued (sale)

If market value is lesser than intrinsic value = undervalued (Buy)
If market value is equal to the intrinsic value = fairly valued
Real Assets: Tangible, physical, value of these assets is inherited in asset itself
Financial Assets: Pieces of paper evidencing a claim on some issuer.

Intrinsic Value of financial assets = present value of all future cash inflows
Cost of Capital (WACC)
The required rate of return on the various types of financing. The overall cost of capital is a
weighted average of the individual required rates of return (costs)
Cost of Debt (Kd)
The required rate of return on investment of the lenders of a company
Cost of Common Equity (Ke)
The required rate of return on investment of the common shareholders of the company
Cost of Preferred Stock (Kp)
The required rate of return on investment of the preferred shareholders of the company

Suppose amount required = 100,000

IRR/ Project Rate = 17.3 %

Company decided to issue debt securities of 40,000 at 12 percent and 30000 will be raised by
issuing preference shares at 13 percent. Remaining amount will be raised by issuing common
stock. The required rate of return by common stock holders is 16 percent. Tax rate = .40

Debt = 40,000 Wd = .40, Kd = .12

Pref Stock = 30000 Wp = .30, Kp = .13
C. Stock = 30000 We = .30, Kd = .16

WACC = (Wd)(Kd)(1-t) + (We)(Ke) + (Wp)(Kp)

WACC = (.40)(.12)(1-.40) + (.30)(.16) + (.30)(.13)

WACC = .136 or 13.6 %

Takeover
Transfer of control of a firm from one group of shareholders to another

• Acquisition
• Merger or Consolidation

Acquiring Firm ……………. Bidder

Acquired Firm ……………… Target Firm

Merger means complete absorption of one company by another wherein the

acquiring firm retains its identity and the target firm ceases to exist as a separate
entity

Co A acquired Co B wherein company B ceases to exist and Co A retains it

identity

Consolidation: A merger in which an entirely new firm is created and both the
acquired and acquiring firm cease to exist

Co A acquiring company and Co B target company ceases their existence and a

new firm “Firm AB” is created

• Acquisition of Stock

A way to acquire another firm by simply purchasing the firm’s voting stock with
an exchange of cash, shares of stock, or other securities. Normally bidder firm
makes tender offer in the market. Tender offer means a public offer by one firm to
directly buy the share of another firm

• Acquisition of Assets
A firm can effectively acquire another firm by buying most or all of its assets.

Acquisition Classifications

• Horizontal Acquisition

This is an acquisition of a firm in the same industry as the bidder

• Vertical Acquisition

A vertical acquisition involves firms at different step of the production

process.

• Conglomerate Acquisition
 When the bidder and the target firms are in unrelated lines of business, the
merger is called a conglomerate acquisition

• Proxy Contest

When a group attempts to gain controlling seats on the board of directors by voting in
new directors. A proxy is the right to cast someone else’s votes. In a proxy contest,
proxies are collected by an unhappy group of shareholders from the rest of the
shareholders.

• Going Private

In going private transaction, all of the equity shares of a public firm are purchased by a
small group of investors. Usually, the group includes members of existing management.

• Leveraged Buyouts (LBOs): Buyout using borrowed money

• Management Buyouts (MBOs): Management is heavily involved in going private
transaction

Joint Venture

Typically an agreement between firms to create a separate co-owned entity established to pursue
a goal

Strategic Alliance

Agreement between firms to cooperate in pursuit of a joint goal

Antitakeover Defensive Strategies/Tactics

• Repurchase and Standstill Agreements / Greenmail

Standstill agreements are contracts wherein the bidding firm agrees to limit its holding in
the target firm. It will normally be followed by a targeted repurchase of target company
stock at premium.

• Supermajority Amendment
Supermajority is required in case of takeover instead of simple majority

• Counter Tender Offer (Pac-man defence)

Target Company will make a counter tender offer to the bidding company shareholders

Co A wants to takeover company B and made a tender offer to Company B shareholders.

In response company B make a counter offer to Co A shareholders

• Fair Price Provision

 A fair price provision means that all selling shareholders will receive the same price from
the bidder.

Tender Offer: Offer by bidding firm to the shareholders of target firm to buy shares at a
certain price

Two Tier Tender Offer

First 20000 shares at 25
Remaining shares at 20

• Bear Hug
A bear hug is an unfriendly takeover designed to be so attractive that the target firm’s
management has little choice but to accept it.

• Golden Parachute
Some target firms provide compensation to top-level management if a takeover occurs.
Depending on your perspective and the amounts involved, golden parachute can be
viewed as payment to management to make it less concerned for its own welfare and
more interested in stockholders when considering a takeover bid.

• Dual Class Capitalization

A company issue dual class of shares where voting right may vary for each class of
shares. For example, a company issued Class A shares (with one vote each share) and
Class B shares (with two votes each share) has typically concentrated power in class B
shares.

• Proxy War

To counter the proxy contest, company management is also involved in proxy contest

• White Knight
A firm facing unfriendly merger offer might arrange to be acquired by a different,
friendly firm. The firm thereby rescued by a white knight. Usually, the friendly firm
retains the existing management.

• Lady Macbeth Strategy

White Knight betrays the target firm and supports the bidder

• Staggered Board

A system in which a company only open up a portion of their director position at election
time. For example, a company with nine board members divided into three classes, will
choose 3 directors at every election. This will increase the time required to take over the
company and may help existing management to avoid it.
 • Poison Pill

Poison pill is a defensive tactic utilized by existing management to make the company
unattractive for the hostile bidder

• Selling the crown jewel: selling the most profitable segment of the
business
• Issue of debt securities repayable in case of takeover
• Issue of shares to at discount diluting the ownership concentration which
may increase the percentage of shares required for any takeover

Divestitures and Restructurings

Divestitures
The sale of assets, operations, divisions, and/ or segments of a business to a third party

Reasons of divestitures unrelated to Merger and Acquisition

• An unprofitable segment is sold
• Profitable segment sold to realize the gains
• Sometimes firm in liquidity problem may sale their assets/segments
Equity Carve-out
The sale of stock in a wholly owned subsidiary via an IPO
Instead of selling a complete segment/unit, a company may create a subsidiary company of that
segment (because the segment is large to be sold). Next, the parent company arranges an IPO in
which a fraction, perhaps 20 percent of the shares is sold.
Spin-Off
The distribution of shares in a subsidiary to existing parent company shareholders on pro-rate
basis. Very commonly, a company will first do an equity carve-out to create an active market for
the shares and then subsequently do a spinoff of the remaining shares at a later date.
Split-Up
The splitting up of a new company into two or more companies

Stock Market Index

The primary objective of the KSE100 index is to have a benchmark by which the stock price
performance can be compared to over a period of time.

Total listed firms at Pakistan stock Exchange = 540 representing 36 sectors (including open
ended mutual funds)
• Sector Based Representation
Out of the following 36 Sectors, 35 companies are selected i.e. one company from each sector
(excluding Open-End Mutual Fund Sector) on the basis of the largest Free-Float Capitalisation
Market Capitalization = MPS * Number of shares
Free Float Market Capitalization= MPS * Number of free float shares

Free-Float means proportion of total shares issued by a company that are readily available for
trading at the Stock Exchange. It generally excludes the shares held by controlling directors I
sponsors I promoters, government and other locked-in shares not available for trading in the
normal course.

Number of Firms = 100

Sector based representation = 35
-------------
= 65 companies
• Capitalization Based Representation

The remaining 65 companies are selected on the basis of largest Free-Float Capitalisation in
descending order.

KSE 100 index calculation = (overall market capitalization / Base ) * 1000

Day 1
Suppose total free float market capitalization of 100 firms at Day 1 is 1000,000
KSE 100 index calculation = (overall market capitalization / Base ) * 1000
KSE 100 index calculation = (1000,000/ 1000,000 ) * 1000
KSE 100 index calculation = 1000

Day 2
Suppose total free float market capitalization of 100 firms at Day 2 is 1200,000

KSE 100 index calculation = (overall market capitalization / Base ) * 1000

KSE 100 index calculation = (1200,000/ 1000,000 ) * 1000
KSE 100 index calculation = 1200
Day 3
Suppose total free float market capitalization of 100 firms at Day 2 is 900,000
KSE 100 index calculation = (overall market capitalization / Base ) * 1000
KSE 100 index calculation = (900,000/ 1000,000 ) * 1000
KSE 100 index calculation = 900
Re-composition of Index
Re-composition period = 6 months
• Time Based Rule
A company (not in the index) which becomes the largest in its sector (by any amount of
value) will enter the index after maintaining its position as largest in the sector for two
consecutive re-composition periods.

1st Re-composition

Suppose company A was the largest in its sector and after 6 months during re-
composition following were the free float market capitalizations
 Company A free float market cap = 100,000
Company B free float market cap = 102,000

2nd Re-composition

Suppose after another 6 months during re-composition following were the free float
market capitalizations

Company A free float market cap = 108,000

Company B free float market cap = 105,000

3rd Re-composition

Suppose after another 6 months during re-composition following were the free float
market capitalizations

Company A free float market cap = 110,000

Company B free float market cap = 112,000

4th Re-composition

Suppose after another 6 months during re-composition following were the free float
market capitalizations
 Company A free float market cap = 112,000
Company B free float market cap = 118,000

• Value Based Rule

A company (not in the index) which becomes the largest in its sector by a minimum of
10% greater in capitalisation value than the present largest in the sector (in the index) will
enter the index after one re-composition period.

1st Re-composition

Suppose company A was the largest in its sector and after 6 months during re-
composition following were the free float market capitalizations

Company A free float market cap = 100,000

Company B free float market cap = 112,000

Note: Both Time based and value based rules are applicable on sector based 35 firms,
however, only time based rule is applicable on capitalization based 65 firms.

Rules for New Issue

A newly listed company or a privatized company shall qualify to be included in the

existing index (after one re-composition period) if the Free-Float Capitalisation of the
new or privatized company is at least 2% of the total Free-Float Capitalisation.
Exercise 1

Lease Case
•

Cost of Buying Machine = 11.4 million

Economic Life = 5 year

Borrowing Rate =11.7 (1- .34)

After tax borrowing rate = 7.722 %

Instalment/Rental = 2470000

After tax rental = 2470000 * 66 /100 = 1630200

Depreciation = 11400000/5 = 2280000 * 34 /100 = 775200

Cost of Borrowing = 11400000

Cost of Leasing

Cost of Leasing = PV of lease rental + Pv of dep tax benefit forgone

Cost of Leasing =R + tax benefit depreciation

 Cost of Leasing = 1630200 + 775200

Cost of Leasing = 6556887 + 3117960

Cost of Leasing = 9674847 $

•
Cost of Leasing = R + tax benefit depreciation + SV / (1+i)n

Cost of Leasing = 6556887 + 3117960 + 1800000 / (1+.07722)5

Cost of Leasing = 6556887 + 3117960 + 1240939

Cost of Leasing = 10915786

Lease is better due to less overall cost

d) Cost of Leasing = R (1+i) + tax benefit depreciation forgone + SV / (1+i)n

Cost of leasing = 1630200 (1+.07722) + 775200 + 1800000 / (1+.07722)5

Cost of Leasing = 7063210 + 3117960 + 1240939

Cost of Leasing = 11421977 $

c)
Lease Rental = 2300000

After tax lease rental = 2300000* 66/100 = 1518000

Cost of Leasing = 1518000 + tax benefit dep + SV/(1+i)n + SD - SD/(1+i)n

Cost of Leasing = 1518000 + 775200 + 1800000/(1+.07722)5 + 1000000 - 1000000/(1+.07722)5

Cost of Leasing = 6105603 + 3117960+ 1240939 + 1000000 – 689411

Cost of Leasing = 10775091 $

e) Lease Rental = 2300000

After tax lease rental = 2300000* 66/100 = 1518000

Cost of Leasing = 1518000 + tax benefit dep Forgone + SV/(1+i)n + SD - SD/(1+i)n

Cost of Leasing = 1518000 + 3542393+ 1800000/(1+.07722)5 + 1000000 - 1000000/(1+.07722)5

Cost of Leasing = 6105603 + 3542393+ 1240939 + 1000000 – 689411

Cost Leasing = 11199524

PV of depreciation tax benefit forgone

1. 11400000 * 33.33 /100 = 3799620 * .34 = 1291871 / (1+ .07722)1 = 1385144

2. 11400000 * 44.45 /100 = 5067300 * .34 = 1722882 / (1+ .07722)2 = 1484727

3. 11400000 * 14.81 /100 =1688340 * .34 = 574036 / (1+ .07722)3 = 459225

4. 11400000 * 7.41 /100 = 844740 * .34 = 287212 / (1+ .07722)4 =

213297
---------------------
Total dep tax benefit forgone =
3542393

Case (Lease or Buy Decision):

Arizona Construction Company is engaged in the business of constructing
buildings. It needs to buy a new Tower Crane costing $10 million. This machine will have a
useful life of 7 years. The company wants to know that whether it is beneficial to buy the
machine or taking machine on lease. So, it asks it’s finance manager Mr. Ahmed to do analysis
and guide the company in making that decision. Mr. Ahmed contacts the bank to get some
necessary information about leasing. The bank tells Mr. Ahmed that the borrowing rate is 13%
and the corporate tax rate is 40%. The bank representative informed Mr. Ahmed that the
company would have to pay an annual lease payment of $1.9 million.
Requirements:
• Based on the given information which option would be better for the company buy or
lease?
• If the machine has an after tax residual value of $1.5 million which option would be
better?
• The company decided to take machine on lease and a representative from company went
to the bank to sign the lease agreement, he was told that the lease payments should be
made at the start of the year, what should the company do now?
• The amount of lease exceeds the amount of buy so the bank made another offer that if the
company pays an advance of $1 million the bank will reduce the amount of lease
payment to $1.7 million. The amount payed in advance will be refunded at the end of the
agreement. Which option is better now? Lease payment at the start of year and residual
value are same.
• What will be your decision if MACRS depreciation method is applied and the machine
falls under 5 years property class?
• Compare lease with borrow and buy under following circumstances
• Residual value pre-tax
• lease payments made in advance are treated as prepaid expenses and expire at the end
of the year when tax will become due
 • PV of bank instalment
• Show interest tax shield benefit
• PV of depreciation tax shield if machine falls in 5 years property class.

Solution:
Given data:
Cost: $10 million
Kd: 13%
Tax rate: 40%
Instalment: $1.9 million
Useful Life: 7 years
I = kd(1-tax rate) = 0.13(0.60) = 0.078
• Buy or Lease:

PV of depreciation tax shield benefit:

$10000000/7 = 1428571* 0.40 = 571428

PVA =
=
= 571428(5.2421730744) = 2995524
PV of instalments:
$1900000*0.60 = $1140000
=
= $1140000(5.2421730744)
= $5976077
Lease = pv of dep tax shield + pv of instalment
 = $2995,524 + $5976077 = $8971,601
The amount is lease is less than buy at present. so, lease is better than buy.

• Residual Value: ($1500000 after tax):

Pv =

Pv = = $886,666
Lease = pv of dep tax shield + pv of instalment + pv of residual value
= $2995,524 + $5976077 + $886,666
= $9858,267

Still the amount of lease is less than buy.so, lease is better than buy.

• Lease payment should be made at start of year:

PVAD = (1+i)
= (1+0.078) = $6442211
Lease = pv of dep tax shield + pv of instalment + pv of residual value
= $2995,524 + $6442211 + $886,666
= $10,324,401
The amount of lease exceeds the amount of buy. Now, buy is better than lease.

• If company pays advance of $1 million and instalment reduces to $1.7

million:

Lease = pv of dep tax shield +amount of advance+pv of residual value+ pv of instalment-

pv of advance returned
= $2995524+$1000000+$886666+ (1+0.078)-
= $2995524+$1000000+$886666+$5764084-$591111
= $10,055,163
Still buy is a better option.

• MACRS (5 years):

years Cost * % Dep *tax rate Pv = Pv of dep tax

shield
1 $10000000 * 0.20 $2000000*0.40 $742115
2 $10000000 * 0.32 $3200000*0.40 $1101469
3 $10000000 * 0.192 $1920000*0.40 $613063
4 $10000000*0.1152 $1152000*0.40 $341222
5 $10000000*0.1152 $1152000*0.40 $316533
6 $10000000*0.0576 $576000*0.40 $146815
Total = $3261217

•
Pv of instalment + pv of depreciation tax shield
= + $3261217
= $1140000(5.2421730744) + $3261217
= $5976077+$3261217
= $9237294
Lease is better than buy.
•
= Pv of instalment + pv of depreciation tax shield+ pv of residual value
= + $3261217+
= $5976077+$3261217+$$886,666
= $10123960
Buy is better than lease.
•
 =Pv of instalment + pv of depreciation tax shield+ pv of residual value
= (1+0.078) + $3261217+
= $6442211+$3261217+$886666
= $10590094
Buy is better than lease.
•
=Pv of instalment + pv of depreciation tax shield+ pv of residual value+ amount of advance –
pv of advance
= (1+0.078) + $3261217++ 1000000-
=$5764084+$3261217+$886666+1000000-$591111
= $11503078
Buy is better than lease.
• Borrow and Buy: (Purchase of machine by taking loan)
Cost: $10 million
Kd: 13%
Tax rate: 40%
Instalment: $1.9 million (at the beginning of year)

Useful Life: 7 years

I = kd(1-tax rate) = 0.13(0.60) = 0.078
• Residual Value: ($1500,000 before tax):
$1500,000 * 0.60 = $900,000
PV = $532000
• Pv of lease Rentals:

Years Rental Tax Net Pv

(Rental*0.40)
0 $1900000 $1900000 $1900000
1 $1900000 $760000 $1057514
2 $1900000 $760000 $980996
3 $1900000 $760000 $910015
 4 $1900000 $760000 $844170
5 $1900000 $760000 $783089
6 $1900000 $760000 $726428
7 0 ($760000) ($449244)

PV of lease rentals: $6752968

• PV of Bank Instalment:
Amount of instalment:
PVAD = (1+i)
$10000000 = (1+0.078)
R = $2000981
PV of Bank instalments:
PVAD = (1+i)
= (1+0.078)
= (200981)(5.6510625742)
= $11307,669

(d) PV of interest shield benefit:

Amortization Schedule:

Years Instalment Interest Principle Principle o/s

(principle (instalment-
o/s*kd) interest)
0 $2000981 7999019
1 $2000981 $1039872 961109 7037910
2 $2000981 $914928 1086053 5951857
3 $2000981 $833260 1167721 4784136
4 $2000981 $621938 1379043 3405093
5 $2000981 $442662 1558319 1846774
6 $2000981 $240081 1846774

PV of interest shield benefit:

Years Interest*tax rate PV
1 $1039872*0.40 $385853
2 $914928*0.40 $314926
 3 $833260*0.40 $266063
4 $621938*0.40 $184219
5 $442662*0.40 $121629
6 $240081*0.40 $61193

Total = $1333883
(e) PV of dep tax shield:
= $3261217
Solved this in requirement 4.
Purchase of asset by taking loan:
= PV of bank instalment – PV of dep tax shield – PV of residual value – PV of interest tax
shield
= $11307669 - $3261217 - $532000 - $1333883
= $ 6180569
Present value of lease rental = $6752968
Purchase of asset by taking loan is better.

Lease Case

Mr. Ahmed is working for a company which needs a machine that may cost the company Rs.11.8

million. This machine will have an economic life of five years. The management of the company

is planning to borrow the money to finance the machine. You are asked by the management to

make an assessment about the possible cost of leasing instead of buying. For this purpose, you

have to contact the bank to get details about leasing. The current borrowing rate is 12.4% and the

tax rate is 40%. The bank representative informed you that the company would have to make an

annual lease payment of Rs.2.40 million.

• On the basis of above information, what would you recommend to your company and

why?
• While making assessment, the manager informed you that the machine have an after tax

residual value of Rs.2.6 million at the end of lease or economic life? Will your answer in

part (i) changed? If not then why?

• The day you went to the bank to sign the lease agreement, the bank representative

informed you that the lease payments would have to make by the company at the start of

the year. What would be your decision now?

• If the cost of leasing exceeds the buying cost, the in that case bank offered to decrease its

annual lease payment to Rs.2.2 million, if the company pays a security deposit of 1.2

million at the time of lease agreement. By considering this offer will your assessment

change or not? The condition of lease payment at start of year and residual value remains

same.

• If company has shifted to MACCRS depreciation method, what would be your decision?
Suppose the machine falls under three year property class.

• Make fresh assessment by comparing lease option with borrow and buy by considering

following points:

• Residual value is pre-tax.

• Lease payments of 2.4 million made in advance are prepaid expenses which

we expire at the end of the year when tax will become due.
 • Suppose no security deposit is required

• Suppose MACRS depreciation is used

• Instalment payment to the bank in borrow and buy option contain interest

expense which is tax deductible (show interest tax shield benefit)

• Suppose bank will charge 12.4 percent on the loan (Bank IRR = 12.4 %)

Solution

1)

Cost of Buying = 11800000

Life = 5 years
Kd = 12.4 %
After tax = 12.4 ( 1 -.40) = .0744
Rental = 2.4 million
After tax Rental = 2400000 (1 - .40 ) = 1440000
Depreciation = 11800000/5 = 2360000 * .40 = 944000

Cost of Leasing = Cost of Leasing = PV of lease rental + Pv of dep tax benefit forgone

Cost of Leasing =R + tax benefit depreciation

Cost of Leasing = 1440000 + 944000

Cost of Lease = 5835372 + 3825410

Cost of Lease = 9660782

2)
Cost of Leasing = R + tax benefit depreciation + SV / (1+i)n

Cost of Leasing = 1440000 + 944000 + 2600000/ (1+.0744)5

Cost of Lease = 5835372 + 3825410 + 1816115

Cost of Lease = 11476897

3)

Cost of Leasing = R (1+i) + tax benefit depreciation + SV / (1+i)n

Cost of Leasing = 1440000 (1+.0744) + 944000 + 2600000/ (1+.0744)5

Cost of Lease = 6269524 + 3825410 + 1816115

Cost of Lease = 11911049

4)

Lease Rental = 2200000

After tax = 2200000 ( 1- .40 ) = 1320000

Cost of Leasing = R (1+i) + tax benefit depreciation + SV / (1+i)n + SD - PV of SD

Cost of Leasing = 1320000 (1+.0744) +944000 + 2600000/ (1+.0744)5 + 1200000 – 1200000 / (1+ .0744)5
Cost of Lease = 5747063 + 3825410 + 1816115 + 1200000 - 838207

Cost of Lease = 11750381

5)

Lease Rental = 2200000

After tax = 2200000 ( 1- .40 ) = 1320000

Cost of Leasing = R (1+i) + tax benefit depreciation + SV / (1+i)n + SD - PV of SD

Cost of Leasing = 132000 (1+.0744) + + 2600000/ (1+.0744)5 + 1200000 – 1200000 / 1+( .0744)5

Cost of Lease = 5747063 + 4107884 + 1816115 + 1200000 - 838207

Cost of Lease = 12032854

• 11800000 * .3333 = 3932940 * .40 = 1573176 / ( 1+ .0744)1 = 1464237

• 11800000 * .4445 = 5245100 * .40 = 2098040/ ( 1+ .0744)2 = 1817531

• 11800000 * .1481 = 1747580 * .40 = 699032 / ( 1+ .0744)3 = 563636

• 11800000 * .0741 = 874380 * .40 = 349752 / ( 1+ .0744)4 = 262479

 = 4107884

6)
Lease Option

Cost of Lease = PV of lease rental + PV of depreciation tax shield + PV of Salvage value

Cost of Lease = 6558958 + 4107884 + 1089669
Cost of Lease = 11756511

PV of Salvage Value
Pre-tax salvge = 2600,000
After tax salvage value = 2600000 * 60/100 = 1560000 / / 1+( .0744)5 = 1089669

Lease Rental Tax Shield Benefit PV of Lease Rentals

0 2400000 • 2400000 = 2400000
1 2400000 2400000* 60 /100 = 1440000 1440000/ (1+.0744)1 = 1340283
2 2400000 2400000* 60 /100 = 1440000 1440000/ (1+.0744)2 = 1247471
3 2400000 2400000* 60 /100 = 1440000 1440000/ (1+.0744)3 = 1161086
4 2400000 2400000* 60 /100 = 1440000 1440000/ (1+.0744)4 = 1080683
5 0 2400000 * 40 /100 = 960000 960000 / (1+.0744)5 = (670565 )
PV of Lease Rentals 6558958

Cost of Buying
Loan Amount = 11800000
Bank IRR = 12.4 %
N = 5 Years
Bank Instalment = ?

Loan = R (1+i)

11800000 = R (1+.124)
 = 2941222

Cost of Buying = PV of bank instalment - PV of Interest exp benefit in instalments

Cost of Buying = 12805598 - 1005597
Cost of Buying = 11800001

PV of Bank Instalment = R (1+i)

PV of Bank Instalment = 2941222 (1+.0744)

PV of Bank Instalment = 12805598

Instalment Interest Expense Principal Principal

Outstanding
0 2941222 - 2941222 8858778
1 2941222 8858778 * .124 = 1098488 1842734 7016044
2 2941222 7016044 *.124 = 869990 2071232 4944812
3 2941222 4944812*.124 = 613156 2328066 2616746
4 2941222 2616746 * .124 = 324476 2616746 0

Interest Tax Shield

Interest Tax Shield Benefit PV of Int. Tax Shield Benefit
1 1098488 * .40 = 439395 439395 / (1+.0744)1 = 408968
)2
2 869990 * .40 = 347996 347996 / (1+.0744 = 301468
3 613156 * .40 = 245262 245262 / (1+.0744)3 = 197757
4 324476 * .40 = 129790 129790 / (1+.0744)4 = 97404

PV of tax shield benefit = 1005597

• Lessee
The user of an asset in a leasing agreement. The lessee makes payments to the lessor.
• Lessor
The owner of an asset in a leasing agreement. The lessor receives payments from the lessee.
• Operating Lease (Partially Amortized Lease)
Usually a short term lease under which lessor is responsible for insurance, taxes and upkeep.

May be cancellable by the lessee on short notice.

• Payments received by lessor are not enough to allow the lessor to fully recover the

cost of asset. A primary reason is that operating leases are often relatively short term.

Therefore, the life of the lease may be much shorter than the economic life of an

asset.

• The lessor in an operating lease expects to either lease the asset again or sell it when

lease terminates.

• The lessor in an operating lease expects to pay for any taxes or insurance. Of course

these costs will be passed on, at least in part to the lesser in the form of higher lease

payments.

• It provides cancellation option which means that lessee has the right to cancel the

lease before the expiration date. If the option to cancel is exercised the lessee returns

the equipment to the lessor and ceases to make payment.

• Financial Lease (Fully Amortized Lease)

Typically a longer term, fully amortized lease under which the lessee is responsible for

maintenance cost, taxes and insurance. Usually not cancellable by lessee without a

penalty.

• The payments made under a financial lease (plus the anticipated residual, or

salvage value) are usually sufficient to fully recover the lessors cost of purchasing
 the asset and pay the lessor a return on the investment.

• The lessee (not the lessor) is responsible for insurance, and taxes

• Financial lease generally cannot be cancelled at least without a significant penalty.

Following are the types of financial leases.

• Tax Oriented Lease (true lease)

A lease in which the lessor is the owner of leases asset for tax purpose. Lessee cannot

efficiently use tax credits or depreciation dedications that come with owing the asset. By

arranging for someone else to hold a title, a tax lease passes these benefits on. The lessee

can benefit because the lessor may return a portion of the tax benefits to the lessee in the

form of lower lease payments.

• Conditional Sale Agreement Lease

Conditional sale agreement lease is a lease where lessee takes possession of assets but its

title and right of possession remains with seller. Lessee in this case can take benefits of

tax and depreciation deductions.

• Means that seller sells the assets and transfers the possession to the purchaser, but

retains title to the asset until the purchaser has fully paid for it.

• As per law owner is the person that has the benefits and burdens of ownership and

not necessarily the owner of legal title.

• Leveraged Lease

A leveraged lease is a tax oriented lease in which the lessor borrows a substantial portion

of the purchase price of the leased assets on a nonrecourse basis, meaning that if the

lessee defaults on the lease payments, the lessor does not have to keep making the loan

payments. Instead, the lender must proceed against the lessee to recover its instalments.

In contrast, with a single-investor lease, if the lessor borrows the purchase the asset,

lessor remains responsible for loan payments whether or not the lessee makes the lease
payments.

• Sale and Lease Back

A financial lease in which the lessee sells an asset to the lessor and then leases it back

Accounting ad Leasing

• Balance Sheet with Purchase

The company finances a $ 100,000 truck with debt

Balance Sheet
Assets Amount Liab + Equity Amount
Truck 100,000 Debt 100,000

Other Assets 100,000 Equity 100,000

200,000 200,000
• Balance Sheet with Operating Lease
The company finances the truck with an operating lease

Balance Sheet
Amount Amount
Truck 0 Debt 0

Other Assets 100,000 Equity 100,000

100,000 100,000

• Balance Sheet with Capital Lease

The company finances the truck with a capital lease

Balance Sheet
Amount Amount
Assets under capital lease 100000 Obligation under capital 100,000
lease
Other Assets 100,000 100,000
Equity
200,000 200,000

For accounting purpose and must therefore be disclosed on the balance sheet if atleast

one of the following criteria is met.

• The lease transfer ownership of the property to the lessee by the end of the term of the

lease

• The lessee can purchase the asset at a price below fair market value (bargain
 purchase price option) when lease expires

• The lease term is 75 percent or more of the estimated economic life of the asset.

• The present value of the lease payment is atleast 90 percent of the fair market value of

the asset at the start of the lease.

PV of lease payments = 90 % of price of asset

• A firm might be tempted to try and “cook the books” by taking advantage of

the somewhat arbitrary distinction between operating and capital leverage.

Suppose a firm wants to lease a $1000000 asset which is expected to last for

15 years.

• A manager can hide such lease which is also unethical by

• Negotiating a lease contract of 10 years

• With lease payments having present value of 89000$.

• Same way term (a) and (b) can be removed

This may help managers to hide the lease from the balance sheet

• It may help to understate true degree of financial leverage i.e total debt/total

assets

• If managers are asked not to make capital spending, on operating lease still be

an option

• Firms facing restrictions on taking further debt may make an operating lease

contract