AG985 / AG993 WORKSHOP 1

Please note that some of these questions are included for additional work but are not
expected to be covered during the tutorial session. The tutorial will focus on Qs 1, 4, 5 and
6. Solutions will be provided to all questions.

Question 1
Brody plc is expected to generate earnings before interest and tax of £40 million next year. It is
an all equity financed company that is run efficiently. Following discussions with the
company's merchant bank a proposal for financial restructuring is under consideration. It has
been suggested that the company raise £100 million through an issue of bonds at 6% and to
use the proceeds to buy back shares in the company. With a corporate tax rate of 30% the cost
of debt is believed to be well below that of equity. The company has 100 million shares
outstanding and the share price is currently £2.50.

a. Determine the expected EPS for the company before and after the proposed
restructuring, and level of earnings before interest and tax at which the EPS would
be the same for the alternative capital structures.

b. With reference to the calculations above, explain why earnings per share is higher for
the geared scenario but why this does not mean that shareholder’s wealth will be
increased or decreased.

Question 2
Florence Plc has 200million shares outstanding at a price of 200pence per share. The
company is seeking to expand its operations, and requires raising £100million of new capital
for its new investments. The company has identified two funding opportunities; either to
raise the funding via a public bond issue at an annual interest payment of 7 per cent, or
alternatively to raise the finance through selling new shares at the current market price.
Irrespective of the funding method chosen the company expects to generate expected
earnings before interest and taxes (EBIT) £50million per annum in future years. The
company pays tax on profits at a rate of 24 per cent.

a) Determine the EPS for the two financing possibilities following the implementation of
the investment.

b) If the debt financing leads to a higher EPS is this a sufficient basis to decide to
employ the debt rather than equity financing?

c) Earnings are uncertain and could fall below the expected level. At what level of
earnings will the EPS turn out to be the same for the equity and debt financing plans?
Question 3
KSY Plc is expected to generate annual earnings before interest and taxes of £50million in
perpetuity. The firm is currently all equity financed. KSY has 80million shares outstanding
at a current market price of £2.50 per share. The firm is considering buying back 25 per cent
of its shares at the current market price and replacing them with debt. The company can
borrow at an interest rate of 5 per cent. Interest payments on corporate debt are tax
deductible and the corporate tax rate is 30 per cent.

a) Determine the cost of the company’s capital before the proposed restructuring.

b) Determine a value for the company following the restructuring.

c) Determine the cost of equity capital and the weighted average cost of capital
following the introduction gearing.

Question 4
Amos plc has always limited its borrowing to an overdraft to cover any unanticipated short
term funding requirements. Its management is considering borrowing on a long term basis
for the first time to finance a major investment programme. It has been established that it
is possible to borrow £200 million at an interest rate of 7 per cent to cover the cost of the
proposed capital expenditure. Alternatively it could issue 100 million shares at the
prevailing market price of £2.00 through a private placement. The market has been kept
informed of the company’s investment plans and it is anticipated that such an issue will
leave the share price unchanged. The company currently has 240 million shares
outstanding. The company's expected earnings before interest and taxes for next year, after
taking the expansion of the company's assets into account, has been estimated to be £150
million. Assuming a corporate tax rate of 30 per cent determine:

a) The expected earnings per share of the company under both forms of financing.

b) The level of earnings before interest and taxes at which both financing plans will
produce the same expected earnings per share.

c) Determine the company’s cost of equity capital, assuming that the company issues
additional shares and maintains its established policy of avoiding the use of debt.
Use the Modigliani-Miller model with corporate tax to derive your answer. What
assumptions are made in employing this model?

d) Using the same model specify the value of the company if the company employs the
debt to finance the company, and break down this value into its debt and equity
components.

e) Determine the company’s cost of equity capital and the weighted average cost of
capital if the company employs the debt financing.
Question 5:
Assume that personal taxes have a role to play in the determination of the value of a
company. An ungeared company is valued at £600m. Another company that has identical
assets and earnings employs £200m of debt in its financing. Determine the value of the
geared company if corporation tax is 40 per cent, the personal tax rate on equity income is
10 per cent and the personal tax on interest income is 30 per cent.

Question 6:
Continuing to use the above company and assuming a zero personal tax rate on equity
income determine what the personal tax rate on interest income will have to be to
eliminate the tax advantage of debt.