Assignment On Highsky’s Market Value Capital Structure

Question:

Question 1

Part 1

Determine Highsky’s existing market value capital structure.

Answer 1

The computation for determining the existing market value of capital structure of the company has been presented here- in- below:

High sky  market Value Capital Structure
(In AUD)
Sl. No.	Particulars	Quantity	Amount	Amount
1	Preference Shares	80000	19.16	1532800
2	Equity Shares	100000	15.37	1537000
3	Debentures	7500	210.29	1577175
Market Value	4646975

Further, it shall be pertinent to note that the debt, preference share and ordinary equity are part of the capital structure of the company. For the purpose of computation of market value, no of outstanding has been multiplied with current price.

Part 2

The company adjusts the cash-flows for flotation costs. Discuss the appropriateness of this approach

Answer 2

Flotation cost is the cost which is incurred at the time of issuing a security or raising additional capital. These costs are directly proportional to the amount of capital raised and the type of security issued (AnalystPrep, 2016). There are generally two approaches for adjustment of flotation of cost:

• Incorporation of cost associated with Cost of capital;
• Adjustment of flotation cost with cash flows into value computation.

The second approach is the most recommended approach as the cost is treated as an additional cost to the project rather being directly incorporated into the cost of capital. The same leads to decrease in cost of capital as no adjustment is made and represent a true picture. Further, under this method we first compute the NPV of the project and then the floatation cost is decreased and leads to one to matching of flotation cost with different projects. (FinanceTrain, 2018)

Part 3

Answer 3

Cost of Financing
Sl No	Particulars	Rate	Tax	Net
1	Long Term Debt	12.50%	3.75%	8.75%
2	Preference Shares	11.67%		11.67%
3	Equity Shares	8%		8%

Computation of growth
Dividend	2016	0.982
	2017	1
	Growth	1.83%

Cost of Equity using DGM
Expected dividend	1.018329939
Price	15.37
Cost	8%

Note : Flotation cost has been considered to be adjusted against cash flows not against cost of capital

Part 4

Discuss an alternative manner to calculate the Cost of Equity (Ordinary shares)

Answer 4

The alternative method for computation of cost of equity is Capital Asset Pricing Model. The model is an additive model and is the simplest technique to compute the cost of capital. The formula of the model has been described here-in-below:

On the basis of the above, computation of Cost of equity is made. The model describes relationship between systematic rick and expected return on stock.

Part 5

Discuss an alternative calculation of the growth factor used in the dividend growth model

Answer 5

The method of computation of growth using Return on Equity has been enumerated here-in-below;

Growth=Return on Equity *(1-Divdend Pay out Ratio)

Sl No	Particular	Brief
1	Dividend	1
2	Pay-out Ratio	40%
3	EPS	2.5
4	Return on Equity	15.63%
5	Growth	9.38%

The growth rate under the said method is much higher than comparing past 2 dividends.

Part 6

Assuming that Highsky maintains this optimum market value capital structure, calculate the breaking points associated with each source of capital

Answer 1

Answer 6

Sl No	Particular	Amount	Weight	Break Capital	Break Point
1	Debentures	1500000	34.88%	500000	1433333.33
2	Preference Shares	1200000	27.91%
3	Equity	1600000	37.21%	1200000	3225000
	Total	4300000

Part 7

Using the breaking points developed determine each of the ranges of total new financing over which the company’s WACC remains constant

Answer 7

Sl No	Break Point	Weight	Range
1	1433333	34.88%	0-1433333
2	3225000	37.21%	1433333-3225000
3			3225000- up till required

Part 8

Calculate the WACC for each range of total new financing

Answer 8

Sl No	Range	Source of Capital	Target Proportion	Cost	Weighted Cost
1	0-1433333	Debt	34.88%	5.71%	1.99%
		Preferred	27.91%	11.67%	3.26%
		Common	37.21%	8.46%	3.15%
			WACC	8.39%
2	1433333-3225000	Debt	34.88%	8.48%	2.96%
		Preferred	27.91%	11.67%	3.26%
		Common	37.21%	8.46%	3.15%
			WACC	9.36%
3	32250000- up till required	Debt	34.88%	8.48%	2.96%
		Preferred	27.91%	11.67%	3.26%
		Common	37.21%	9.12%	3.39%
			WACC	9.61%

Sl No	Particulars	Briefs
1	Current Price	210.29
2	Interest	12.5
3	No of coupons	14
4	Maturity Value	200
5	Yield	5.71%

Cost of Equity using DGM
Expected dividend	1.0571
Price	14.5
Cost	9.12%

Part 9

Using your findings above with the Investment Opportunities Schedule (IOS), draw the company’s weighted marginal cost of capital (WMCC) function and IOS on the same set of total new financing or investment (x-axis) – WACC and IRR (y-axis) axes

Investment Opportunity Schedule
Project Identification	Project Cost	Estimated Annual flows	Estimated  Life in Years	Internal Rate of Return
A	4,00,000	82650	6	6.51%
B	200000	52840	5	2.25%
C	800000	163400	7	6.14%
D	500000	115240	6	10.13%
E	300000	61600	7	9.99%
F	500000	158120	4	-3%
G	500000	131270	5	9.81%

Part 10

Which, if any, of the available investments would you recommend the firm accept

Answer 10

The following project will be accepted D, E and G as the internal return on those projects is greater than WACC of the company.

Part 11

Explain your answer, concluding with a discussion of the accept reject decision on the marginal project

The cost of capital of the project ranges from 8.39 % to 9,61% while only three projects fall in the said criteria. Further, the internal return on the project has return from 9.81% to 10.13%. Thus, all the projects have return greater than highest slab of WACC of the company. Accordingly marginal analysis need not be taken as there is no need to fit any project in 1^st slab or 2^nd slab.

Part 12

Assuming that the specific financing costs do not change what effect would a shift to a more highly levered capital structure consisting of 60 per cent long-term debt, 20 per cent preference capital and 20 per cent ordinary equity have on your findings above? (Note: rework the relevant parts above using these capital structure weights)

Answer 12

Break Points

Sl No	Particular	Amount	Weight	Break Capital	Break Point
1	Debentures	1500000	60.00%	500000	833333
2	Preference Shares	1200000	20.00%
3	Equity	1600000	20.00%	1200000	6000000
	Total	4300000

WACC

Sl No	Range	Source of Capital	Target Proportion	Cost	Weighted Cost
1	0-833333	Debt	0.6	5.71%	1.99%
		Preferred	0.2	11.67%	3.26%
		Common	0.2	8.46%	3.15%
			WACC		8.39%
2	833333-6000000	Debt	0.6	8.48%	2.96%
		Preferred	0.2	11.67%	3.26%
		Common	0.2	8.46%	3.15%
			WACC		9.36%
3	6000000- up till required	Debt	0.6	8.48%	2.96%
		Preferred	0.2	11.67%	3.26%
		Common	0.2	9.12%	3.39%
			WACC		9.61%

IRR of projects

Investment Opportunity Schedule
Project Identification	Project Cost	Estimated Annual flows	Estimatd  Life in Years	Internal Rate of Return
A	4,00,000	82650	6	6.51%
B	200000	52840	5	2.25%
C	800000	163400	7	6.14%
D	500000	115240	6	10.13%
E	300000	61600	7	9.99%
F	500000	158120	4	-2.59%
G	500000	131270	5	9.81%

The company WACC has fallen but still now only 3 projects can be accepted as rest other project IRR is lower than lower rang of WACC

Part 13

Which capital structure – the original one or this one – seems better? Why?

Answer 13

The capital structure of the company that the company should choose depends on its profitability requirement and cash flows. Since the second structure involves too much reliance on the debt that can be detrimental to future potential of the company. While, it offers the benefit of trading on equity the company should opt for original capital structure as excess debt can create many problems for the company in future if the cash flows are not as per prediction above.

Answer 2

Question 2

White Ltd operates outdoor amusement centres in a number of country towns. The company has decided to build another centre that is expected to generate a permanent increase in EBIT of $100,000 pa. Current EBIT is $350,000. White currently has a capital structure that utilises bonds, ordinary equity and preference shares. The $200,000 of issued bonds pay 8% pa. Preference shares pay an annual fixed dividend of $150,000. Currently 250,000 ordinary shares have been issued and are trading at $2 per share. The company pays tax at 30%.

Part A

White needs to raise $500,000 to construct the new amusement centre. Assuming the company can issue new shares at the current market price, what is the impact on EPS if new shares are issued to fund the centre?

Answer A

The impact on EPS on account of issue of new equity has been tabulated here-in-below:

EPS Computation
Sl No	Particulars	Amount
1	Current EBIT	350000
2	Proposed EBIT	450000
3	Interest on Bond	16000
4	Current EBT (1-3)	334000
5	Proposed EBT (2-3)	434000
6	Current Tax (4*30%)	100200
7	Proposed Tax(5*30%)	130200
8	Current PAT(4-6)	233800
9	Proposed PAT(5-7)	303800
10	Preference Dividend	150000
11	Profit available to share holder
	-Current (8-10)	83800
	-Proposed (9-10)	153800
12	No of shares outstanding
	-Current	250000
	-Proposed	500000
13	EPS
	-Current	0.3352
	-Proposed	0.3076

Part B

If new debt can be raised at a 10% interest rate, what is the impact on EPS of using debt rather than a new equity issue?

Answer B

The impact of issue of debt instead of equity on EPS has been enumerated here-in–below:

Sl No	Particulars	Amount
1	Current EBIT	350000
2	Proposed EBIT	450000
3	Interest on Bond	16000
4	Interest on Bond (Additional + old)	66000
5	Current EBT (1-3)	334000
6	Proposed EBT (2-4)	384000
7	Current Tax (5*30%)	100200
8	Proposed Tax(6*30%)	115200
9	Current PAT(5-7)	233800
10	Proposed PAT(6-8)	268800
11	Preference Dividend	150000
12	Profit available to share holder
	-Current (9-11)	83800
	-Proposed (10-11)	118800
12	No of shares outstanding
	-Current	250000
	-Proposed	250000
13	EPS
	-Current	0.3352
	-Proposed	0.4752

The proposed EPS has increased significantly.

Question 2-Additional Question

White Ltd depends on mainly on sunny weather to generate its expected EBIT. Using the information above together with the two following scenarios calculate the impact of the debt and equity financing alternatives if:

Part A

Weather is good which will increase attendances and increase EBIT to $600,000

Answer

EPS Computation
Sl No	Particulars	Equity	Debt
1	Proposed EBIT	600000	600000
2	Interest on Bond	16000	66000
3	Proposed EBT	584000	534000
4	Proposed Tax	175200	160200
5	Proposed PAT	408800	373800
6	Preference Dividend	150000	150000
7	Profit available to share holder	258800	223800
8	No of shares outstanding	500000	250000
9	EPS	0.5176	0.8952

Part B

Weather is poor which will decrease attendances and reduce EBIT to $320,000

Answer B

Sl No	Particulars	Equity	Debt
1	Proposed EBIT	320000	320000
2	Interest on Bond	16000	66000
3	Proposed EBT	304000	254000
4	Proposed Tax	91200	76200
5	Proposed PAT	212800	177800
6	Preference Dividend	150000	150000
7	Profit available to share holder	62800	27800
8	No of shares outstanding	500000	250000
9	EPS	0.1256	0.1112

Part C

Calculate the indifference point

Answer C

• Indifference point is the point at which the company shall be indifferent between financing through equity or debt. The same has been enumerated here-in-below:

EPS Computation
Sl No	Particulars	Equity	Debt
1	Proposed EBIT	330285.7	330285.7
2	Interest on Bond	16000	66000
3	Proposed EBT	314285.7	264285.7
4	Proposed Tax	94285.71	79285.71
5	Proposed PAT	220000	185000
6	Preference Dividend	150000	150000
7	Profit available to share holder	70000	35000
8	No of shares outstanding	500000	250000
9	EPS	0.14	0.14

Question 3. (Do any 3 parts)

Tversky and Kahneman (1974) analyse heuristic principles used as devices to reduce the complexity of tasks and to form intuitive judgments of probability – often useful devices, but sometimes leading to systematic mistakes. They draw an analogy with visual perception: we judge the distance of an object by our visual perception of its sharpness and clarity, which is often a useful guide, but in specific circumstances it will be misleading: in fog we overestimate distances; in sunny weather we underestimate them. Similarly, whilst heuristics can be useful devices to enable quick and efficient decision-making, their use does lead to decision-making biases.

Tversky and Kahneman (1972, 1974) explore the connections between heuristics and biases for a range of heuristics commonly employed, including representativeness, anchoring/adjustment and availability. For Tversky and Kahneman, heuristics are intuitive decision-making tools, but the problem is that a range of biases can emerge from the mis-application of these quick decision-making tools. Tversky and Kahneman illustrate with some experimental examples of systematic mistakes from misapplication of heuristics. In describing their experimental evidence, they note that they encouraged their experimental subjects to be accurate and rewarded them for correct answers to deter wishful thinking and other irrational influences not associated with the application of heuristics.

Answer 3

Overall, a large number of heuristics and biases have been identified

Part A

Olivia is in her early twenties, intelligent and socially active concerning social issues and often attends demonstrations concerning these issues. Which is more probable?

Olivia is a bank clerk

Olivia is a bank clerk and involved actively in the feminist movement.

Explain your choice?

Answer A

In the said question, for Olivia to be a bank clerk she needs to be intelligent and there exists a relation between her intelligence and her to be bank clerk. Further, for her being a part of feminist movement, she must be socially active and take part in social demonstrations. Since there is a active correlation between her traits and observation represented in part 2, a probability of her being bank clerk and actively involved in feminist movement can be drawn. (BEHAVIORAL AND BRAIN SCIENCES, 2005)

Part C

A bucket contained around fifty black and red ball.  First draw of five revealed four red and one black. These balls were then returned to the bucket and a draw of twenty balls revealed twelve red and eight black. Which of these draws was more likely to be from a bucket containing two-thirds red balls and one-third black balls?

Answer C

In this problem, the correct posterior odd are 8 to 1 for a 4:1 sample and 16 to 1 for a 12:8 sample, assuming equal prior probabilities. However, there shall be a feeling that the first sample provides a greater and stronger evidence of the hypothesis that the bucket is predominantly red because the proportion of red balls is greater in the first sample than in the second sample. One shall see, here again intuitive judgements have been dominated by the sample proportion and are unaffected by the size of the sample which plays a crucial role in determination of posterior odds (Kahneman and Tversky, 1972). Further, intuitive estimates of posterior odds are far less extreme than the correct values. The above problem is generally referred to as conservatism and draw two are more likely. (BEHAVIORAL AND BRAIN SCIENCES, 2005) 

Part D

Two groups were arranged. The first group contained seventy lawyers and thirty engineers. The second comprised thirty lawyers and seventy engineers. You are informed that one of the people in the groups is called Ben who is thirty-two years old, motivated and highly able, well liked and successful. What is Ben’s occupation? How did you come to your decision?

Answer D

If Ben is in the first group then the probability of him being an lawyer is 70 % while that of an engineer is 70%. Further, if Ben is in the second group, the probability of him being an engineer is 70% and that of lawyer is 30%. Further, by applying Bayes theorem ratio of odds (0.7/0.3)^2 are 5.44 for each description. Further, the description does not have any relevance in determining the position of Ben as he can be both lawyer and engineer, but there shall be a greater probability of lawyer in group 1 and engineer in group 2 and 1:1 change when both group are considered together. The above question is a sheer example of insensitivity of prior probability of outcome.   (BEHAVIORAL AND BRAIN SCIENCES, 2005)

References:

AnalystPrep, (2016), Incorporation of Flotation Costs into Cost of Capital,Retrieved September 9, 2018, from analystprep.com: https://analystprep.com/cfa-level-1-exam/corporate-finance/flotation-costs/

BEHAVIORAL AND BRAIN SCIENCES, (2005), Retrieved September 8, 2018, from pdfs.semanticscholar.org:https://pdfs.semanticscholar.org/ee9d/d3028f999ac560dde661a6c8ab1a50e9eafa.pdf

FinanceTrain, (2018), Flotation Costs and WACC, Retrieved September 9, 2018, from financetrain.com: https://financetrain.com/flotation-costs-and-wacc/