- Describe the following methods of credit enhancement.
- Excess spread.
- Surety bond.
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QUESTION 31
- Credit enhancement is the process of reducing credit risk by requiring collateral insurance or other agreements to provide the lender with the assurance that he will be compensated if the borrower defaulted.
Credit enhancement is a key part of the securitization transaction and is important to credit rating agencies when raising a securitization
Methods of credit enhancement
- Excess spread
Also known as excess interest cash flow. It is the difference between interests received by lenders or issuers of asset based securities (such as morgartges) and interest paid to holders of such securities for example subprime morgartges.
This surplus interest (usually deposited in reserve account) is used as first line protection.
- Over- collateralization
This is the ratio of assets in liabilities. It occurs when the value of the assets held to support a security is actually greater than the security. The ratio of asset to liability should be greater than 1. This gives the holder a cushion in the event of late or non-payment.
- Surety bond
A surety bond is a promise to pay one party (the oblige) a certain amount if a second party (the principal) fails to meet some obligation, such as fulfilling the terms of a contract. It protects the oblige against losses resulting from the principals failure to meet obligation.
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- The following information relates to Unified Holdings Ltd.’s capital structure, whose cost of debt varies according to its gearing level:
Gearing (%) Cost of debt before tax
20 7.5% 30 8.1%
40 8.8%
50 10.5%
60 11%
70 13%
80 16%
Additional information 1. Risk free rate is 8%.
- Market return is 16%.
- Corporate tax rate is 30%.
- The company’s ungeared beta (asset beta) is 0.95
Required;
Unified Holding Ltd’s optimal weighted average cost of capital (WACC).
QUESTION 32
(a) Kitunda Ltd. has estimated the cost of debt and equity for various financing gearing levels as follows: (b)
| Proportion of debt | Required rate of return | |
| Capital | Debt % | Equity % |
| 0.9 | 9.4 | 37 |
| 0.8 | 8.2 | 36 |
| 0.7 | 7.4 | 35.5 |
| 0.6 | 6.9 | 29.1 |
| 0.5 | 6.6 | 25.2 |
| 0.4 | 6.4 | 20.4 |
| 0.3 | 6.2 | 15.6 |
| 0.2 | 6.1 | 13.5 |
| 0.1 | 6 | 13.1 |
| 0 | – | 13 |
Required:
- The optimal capital structure.
- Kitunda Ltd. wishes to transform from its optimal gearing level to all-equity financed firm. Modigliani and Miller’s model with no taxes to determine the equity cost of capital.
(c) Explain the meaning of the “pecking order theory”.
Optimal capital structure rate of return = 12.02 i.e. 20 % debt and 80% equity
- It would be the optimal rate i.e. 15.9
- Reason: weighted average cost of capital remains constant regardless of the debt to equity ratio according to Modigliani and Millers no tax capital structure argument
- c) The pecking order theory says that firms prefer internal financing (that is, earnings retained and re invested) over external financing. If external financing is needed, they prefer to issue debt rather than issue new shares. The pecking order theory starts with the observation that managers know more than outside investors about the firm’s value and prospects. Therefore, investors find it difficult to value new security issues, particularly issues of common stock. Internal financing avoids problem. If external financing is necessary, debt is the first the choice. The pecking order theory says that the amount of debt a firm issues will depend on its need for external financing. The theory also suggests that financial managers should try to maintain it at least some financial slack, that is, a reserve of ready cash or unused borrowing capacity.
QUESTION 33
Furnace Ltd wishes to evaluate two plans, leasing and borrowing to purchase an oven. The firm’s tax rate is 40%.
Lease option: The company can lease the oven under a 5 year lease requiring annual end-of year payments of Sh 5,000,000. All maintenance costs will be paid by the lease, while insurance and other costs will be borne by the lessee. The lessee will exercise its option to purchase the asset for Sh 4,000,000 at termination of the lease.
Purchase option: the oven costs Sh 20,000,000 and will have a five year useful life. Depreciation charges in the five years will be as follows: Year 1 Sh 4,000,000 Year 2 Sh 6,400,000, Year 3 Sh 3,800,000, Year 4 Sh 2,400,000 and Year 5 Sh 2,400,000. (The balance of value being the residual
value).
The total purchase price will be financed by a 5 year, 15% loan requiring equal annual end of year payments of Sh 5,967,000. The firm will pay Sh 1 Million per year for a service contract that covers all maintenance costs. Insurance and other costs will be borne by the firm. The firm plans to keep the equipment and use it beyond its 5 year recovery period.
Required;
- For the leasing option, calculate the following:
- The after tax cash outflow each year.
- The present value of the cash flow, using a 9% discount rate.
- In respect of the purchase options, calculate the following.
- The annual interest expenses deductibles for tax purposes for each of the 5 years. ii) The after-tax cash outflow resulting from the purchase for each of the 5 years iii) The present value of the cash outflow, using a discount rate of 9%
- Compare the present value of the cash outflow streams for the two plans and determine which plan would be preferable.
QUESTION 34
b)Baba Ltd and Toto Ltd are firms operating in the same industry and are considered to be in the same risk class. Each firm has an operating profit of sh. 250,000,000 per annum. The capital structures of the firms are as follows:
| Baba Ltd
Sh. “million” |
Toto Ltd
Sh. “million” |
|
| Equity (market value) | 1,750 | 1,000 |
| 8% debt (Trading at par) | – | 1000 |
| 1,750 | 2,000 |
The two companies have a 100% dividend payout ratio.
Required:
- i) The weighted average cost of capital (WACC) of each of the two firms ii) Comment of the equilibrium position of the equity shares, of the two firms.
iii)Advise Alusa, who holds 4% of Toto Ltd’s equity shares, on the arbitrage opportunities available to him (ignore taxation).
- The two companies are identical, practice Arbitrage to restore the 2 companies to equilibrium. MM maintains that there are no 2 identical firms which can attract different values simply because one firm is levered while another one is unlevered which is the case for the two firms. Therefore if this happens, then investors will practice the arbitrage process to restore the values of the 2 firms to equilibrium.
QUESTION 35
The finance manager of STN Ltd is planning new year’s capital budget. STN ltd expects its net income to be Sh 2,700,000 next year and its current dividend payout ratio is 30%. The company’s earnings and dividends are expected to grow at a constant rate of 8% per annum.
The last divided paid by the company was Sh 1.00 per share and the current equilibrium share price is Sh 16 STN Ltd can raise up to Sh 1,800,000 of debt at 11% before tax cost, the next Sh 1,800,000 will cost 12% and all debt above Sh 3,600,000 will cost13%. If STN Ltd issues new ordinary shares, a 12% underwriting cost will be incurred. STN Ltd can sell the first Sh 200,000 of new ordinary shares at the current market price, but to sell any additional new shares, STN Ltd must lower the price to Sh 14. STN Ltd is at its optimal capital structure, which is 60% debt and 40% equity and the firm’s corporation tax rate is 40%. STN Ltd has the following independent, indivisible and equally risky investment opportunities.
| Project | Cost Sh | Internal rate of return (IRR)
% |
| A
B C D |
3,200,000 1,300,000
1,750,000 450,000 |
13.0
10.7 12.0 11.2 |
Required
- The break points in the marginal cost of capital (MCC) schedule.
- The cost of each component of the capital structure.
- The weighted average cost of capital (WACC) in the interval between each break in the MCC schedule.
- The MCC/IOS graph clearly indicating the projects to be undertaken.
- STN Ltd’s optimum capital budget.
QUESTION 36
Pentel Ltd, a computer assembly company, intends to expand its operations. This will require an expansion of its assets by 50%. The annual incremental sales to be generated by this expansion are estimated to be sh. 18 million with annual incremental earnings before interest and taxes (EBIT) of 25% on incremental sales. All the financing for this expansion will come from external sources as profit retentions are already committed elsewhere.
A financial analyst hired by the company has submitted the following proposals of financing the expansion for consideration:
| Plan A | Issue of 10% debentures |
| Plan B | Issue of 10% debentures for half the required amount and issue of ordinary shares at 25% premium for the remaining balance of the amount. |
| Plan C | Issue of ordinary shares at 25% premium |
The financial of the company for the financial year ended 30 April 2009 are as shown below:
| Pentel Ltd | |||
| Balance sheet as at 30 April 2009 | |||
| Equity and liabilities | Sh. “000” | Assets | Sh. “000” |
| Ordinary shares capital (sh. 10 per value) | 32,000 | Non-current assets | 64,000 |
| 8% debentures | 24,000 | Current assets | 32,000 |
| Retained earnings | 16,000 | ||
| Current liabilities | 24,000 | ||
| Total equity and liabilities | 96,000 | Total assets | 96,000 |
| Pentel Ltd. | |
| Income statement for the year ended 3 | 0 April 2009 |
| Sales | 152,000 |
| Operating costs | (128,000) |
| Debenture interest | 24,000 |
| Earnings before taxes | (1,920) |
| Taxes (30%) | 22,080 |
| Earnings available to ordinary shareholders | 6,624 |
| 15,456 | |
| Earnings per share | 4.83 |
The tax rate is expected to remain constant at 30%.
Required:
- The number of additional ordinary shares to be issued under financial plans B and C.
- The earnings per share (EPS) indifference points between:
- i) Plan A and plan B ii) Plan A and plan C
iii) Plan B and plan C
- Assume that the price/earnings (P/E) ratio will be 8 if plan C is adopted but will drop to 6 if either plan A or plan B is used to finance the expansion.
Determine the market price per share under each financing plan and advise Pentel Ltd, on the best means of financing the expansion.
QUESTION 37
- b) The management of Shujaa Ltd is excited that the government has reduced the corporate tax rate from 33% to 30%. This tax cut is expected to increase the net present value of operating cash flows of the company by sh.15 million.
The current capital structure of the company is as follows:
|
Ordinary share capital (sh. 5 par value) Retained earnings Share premium Shareholders’ equity 10% debentures (sh. 100 par value) |
Sh. “million” 30 70 40 140 40 180 |
The company’s shares are currently selling at sh.32.00 ex-div and the debentures are selling at sh. 135 cum-interest.
The equity beta is 1.2. The market return is 13%. Debt capital is risk free.
Assume that the cost of debt and the market price of the debentures will not change as a result of tax cut.
Required:
- i) Determine Shujaa Ltd’s weighted average cost of capital (WACC) before the tax cut. ii) Determine the expected market price per share of Shujaa Ltd after the tax reduction.
(In answering part (b) (ii) above, use the Modigliani and Miller’s (MM) hypothesis under corporate taxes)
QUESTION 38
Mapema Ltd has the following capital structure which it considers optimal:
| Source of capital | Amount
Sh ‘million’ |
| Ordinary share capital
Preference share capital Long term debt Total |
90.0 22.5
37.5 |
Mapema Ltd expects an after tax income of sh.5143000 in the next financial year. The company has a policy of paying out 30% of its earnings as dividends. Investors expect dividends to grow at an annual rate of 9% indefinitely. The dividend last paid by the company was sh.5.40 per share. The company’s ordinary shares currently sell on the stock market at sh.90 per share .The Company can obtain additional financing in the financial markets as follows:
Long-term debt
Up to sh.7.5 million of long-term debt can be obtained at an interest rate of 12%: long-term debt in the range of sh. 7.5 million to sh. 15 million must carry an interest rate of 14% and all long-term debt over sh.15 million will have an interest rate of 16%. The corporate tax rate is 30% and interest on long-term debt is tax allowable.
Ordinary shares
New ordinary shares of up to sh.18 million can be raised at sh.81 per share. To issue additional shares above sh. 18 million floatation cost of sh. 18 per share must be incurred.
Preference shares
New preference shares with a par value of sh. 100 can be issued and the dividend rate is 11%. However, a floatation cost of 5% of the par value per share must be incurred for all preference shares up to sh.11.25 million. Additional preference shares (above sh.11.25 million) can be raised at a floatation cost of shs.10 per share.
The investment opportunities available to the company are as shown below:
| Investment | Outlay | Annual net cash flow | Life(years) | Internal rate of return (IRR) (%) |
| I
II III IV V |
15000000 15000000
15000000 30000000 30000000 |
3286800 4731630 3255270 5684220 8141760 |
7 5
8 10 6 |
12.0
17.4 14.2 16.0 ? |
Required:
- Determine the break points in the marginal cost of capital (MCC) schedule.
- Calculate the weighted average cost of capital (WACC) in the intervals between the break points in the MCC schedule.
- Calculate the internal rate of return (IRR) for project V.
- Construct an investment opportunity curve (IOC)/ marginal cost of capital (MCC) schedule and indicate which project(s) should be accepted or rejected.
QUESTION 39
(a) Hisa Ltd. has the following capital structure, which it considers optimal.
| Debentures | 25% |
| Preference share capital | 15% |
| Ordinary share capital | 60% |
| 100% |
Additional information:
- Hisa Ltd.’s expected profit after tax for the year ending 31 December 2008 is Sh. 34,285,714.
Hisa Ltd. has an established dividend pay-out ratio of 30%. The tax rate for the company is 30%, and investors expect earnings and dividends to grow at a constant rate of 9% per annum in the future.
- The company paid a dividend of Sh. 3.60 per share in the year ended 31 December 2007. The company’s shares currently sell at Sh. 60 per share.
- The company can obtain new capital as follows:
Ordinary shares: New ordinary share capital can be issued at a floatation cost of 10%
Preference share capital: New preference share capital with a dividend of Sh. 11 per share can be issued the public at Sh. 100 per share. The floatation cost is Sh. 5 per share. Debentures: Debentures can be issued at an interest rate of 12% per annum.
- Assume that the cost of capital is constant beyond the retained earnings break point.
Required:
- Calculate the break point in the marginal cost of capital (MCC) schedule.
- Determine the cost of each capital structure component. iii) Calculate the weighted average cost of capital (WACC) in the intervals between the break point in the marginal cost of capital (MCC) schedule.
- iv) Hisa Ltd. has the following investment opportunities:
| Project | Cost | Internal rate of return (IRR) |
| A | 0 | 17% |
| B | 20,000,000 | 16% |
| C | 10,000,000 | 14% |
| D | 20,000,000 | 14% |
| E | 10,000,000 | 12% |
Which of these projects should the company accept and why?
December 2008 Question Four B
QUESTION 40
(a) The following extract of the balance sheet of Mapato Ltd, shows the capital structure of the company as at 31 December 2007
| Sh. “000” | |
| Ordinary share-capital (par value Sh.125)
Reserves Shareholders’ equity
Long-term liability: 14% debenture stock (par value Sh.500) Capital employed
|
62.500
121.500 184,000
118,500 302,500
|
The management of the company considers the above capital structure to be optimal
Additional information:
- The company’s earnings before interest and tax (EBIT) average sh 75 million per annum. These are expected to be maintained in the foreseeable future
- the ordinary shares are currently trading at Sh 4oo per share
- the market price of the debentures is sh525 per debenture
- The corporate rate of tax is 30 per cent
Required:
Using the net income approach (incorporate taxes), calculate the company’s
- Cost of Equity
- After tax cost of debt(Market value weighted)
- Market-weighted average cost of capital
(b) The following information relates to Abacus Ltd, an all equity financed company
- The market value of a company (determine using the net income approach) is sh. 130 million
- The cost of equity is 16 per cent
- The management of the company intends to replace sh. 8 million worth of equity with debenture of similar value (assume all legal requirement will be fulfilled).The cost of the debenture would be 12 per cent(before tax)
- The company’s earnings before interest and tax (EBIT) are expected to remain constant in the foreseeable future
- All earnings after tax are paid out as dividends
- The corporate rate of tax is 30 per cent
Required:
- Using the Modigliani and Miller (MM) approach, assess the effects of the change in capital structure on the market value of the company, cost of equity and weight average cost of capital.
- Advise the management of the company on whether to change the capital structureThe company should change its capital structure because as the amount of the debt in the capital structure increases, the WACC decreases and the value of the firm increases. This implies that there must be an optimal capital structure where the WACC is minimized and the value of the firm is maximized hence the capital structure decisions are relevant.
QUESTION 41
(a) The following information relates to two firms; Bora Ltd and Beta Ltd:
Firm Sales (Sh.) Variable costs (Sh) Fixed costs (Sh)
Bora Ltd 1,800,000 450,000 900,000
Beta Ltd 1,500,000 750,000 375,000
Required:
- Degree of operating leverage for each firm.
- Comment on how the operating leverage has impacted on the earnings available to shareholders of each firm
QUESTION 42
- b) Dawanox Ltd, an unlevered firm, generates average earnings before interest and tax (EBIT) of Sh. 20 million per annum.the market value of the company as at 31 October 2007, the company’s financial year-end, was Sh.120 million.
The management of the company are considering the use of debt finance and have provided the following additional information:
- the estimated present value of the future financial distress costs is Sh. 80 million
- the probability of financial distress would increase the leverage according to the following schedule:
Value of debt (Sh) Probability of financial distress
25 million 0.0
50 million 0.0125
75 million 0.0250
100 million 0.0625 125 million 0.1250
150 million 0.3125
200 million 0.750
- the corporation tax rate is 30 per cent
Required:
- The company’s cost of equity and weight average cost of capital(WACC) as at 31 October 2007
- The company’s optimal level of debt finance using the Modigliani and Miller (MM) with-tax model (excluding financial distress costs)
- The company’s optimal level of debt finance using the MM with-tax model incorporating financial distress costs.
QUESTION 43
- b) Maisha Ltd and Bora Ltd manufacture wall clocks. The selling price of each clock is sh.1000 with a variable cost of sh.700.Each of the company realizes average annual sales of sh.70,000,000 and incurs average fixed costs of sh.1,700,000 per annum.
However, the two companies differ in their capital structures as stated below:
Maisha Ltd. Is an all-equity financed company having issued 40,000 ordinary shares of sh.10 per value.
Bora Ltd is financed with 20,000 ordinary shares of sh.10 per value and a loan of sh.1600, 000 at an interest rate of 10% per annum
The corporation tax is 30%
Required:
- i) The of operating leverage and financial leverage for each company ii) The degree of combine leverage for each company
iii) The break-even point (in units) for each company. Comment on the significance of your results iv) The earning per share (EPS) at the point of indifference between the earning of the two companies
QUESTION 44
(b) The following balance sheet relates to Mapeo Ltd for the year ending 31 December 2006:
16Retained earnings Current liabilities Ordinary share capital (sh.20 par) Equity and liabilities Assets: NonCurrent assets Total assets total equity and liabilities% debenture (sh.100 par) -current assets Sh.’000’12206040,00060,000102414,000,000,000,000 ,000 ,000
Additional information:
- i) The company’s earnings before interest and tax average sh.16, 000,000 per annum ii) The current market price per share is sh.90
- The corporate tax rate is 30%
- All the company’s profit are distributed as dividends
- Assuming that all the assumptions of the traditional theory of capital structure hold, except for the existence of taxes
Required:
The company’s market-weight average cost of capital using the traditional theory
QUESTION 45
(a) Biashara Ltd is financed by debt and equity. The company is in the process of determining the optimal capital structure that will minimize its weight average cost of capital
The cost of debt at various levels of leverage is as follows:
| Debt to asset ratio | Debt to equity ratio | Cost of debt (before tax) |
| 0
0.2 0.4 0.6 0.8 |
0
0.25 0.67 1.50 4.0 |
7% 8%
10% 12% 15% |
Additional information:
- The company uses the capital asset pricing model (CAPM) to estimate the cost of equity
- The risk free rate is 5% and the market premium is 6%
- The rate of corporate tax is 30 %
- The unlevered beta is 1.2
Required:
The company’s optimal capital structure Note: βL = βU [1+ (1-T) (D/E)] Where: βL =Levered beta βU =Unlevered beta T =tax rate
- =market value of debt
- =market value of equity
QUESTION 46
(a) Two firms. A Ltd. And B Ltd. Operate in the same industry. The two firms are similar in all aspects except for their capital structures.
The following additional information is available.
- A ltd. Is financed using sh.100 million worth of ordinary shares.
- B ltd. Is financed using sh.50 million in ordinary share and sh.50 million in 7% debentures.
- The annual earnings before interest and tax sh.10 million for both firms. These earning are expected to remain constant indefinitely.
- The cost of equity in A LTD.IS 10%. v) The corporate tax rate is 30%.
Required:
Using the Modigliani miller (mm) model, determine the following. i) The market value of A ltd. and B ltd. ii) The weighted average cost of capital of A ltd. And B ltd. (b) Proton ltd. has a capital structure consisting of sh.250 million in 12% debentures and sh.150 million in ordinary share of sh.10 per value. The company distributes all its net earning as dividends.
The financed manager of proton ltd intends to raise an addition sh.50 million to financed the expansion programme and considering the financing options.
Option one: Issue an 11%debenture stock.
Option two: Issue 13%cumulative preference share
Option three: Issue addition ordinary share of SH.10% per value The corporation tax rate is 30%.
Calculate the earning before interest and tax (EBIT) and the earning per share (EPS) at the point of indifference between the following financing options.
- i) Option one and option three. ii) Option two and option three.
