COST OF CAPITAL AND CAPITAL STRUCTURE DECISIONS

1.0 INTRODUCTION
The firm's mix of different securities is known as its capital structure. A firm can issue dozens of
distinct securities in countless combinations that maximises its overall market value. It is important
to ask ourselves whether these attempts to affect its total valuation and its cost of capital by
changing its financial mix, are worthwhile. This will be discussed in this lesson.

The cost of capital has already been discussed in Business Finance and therefore we shall only give
a general discussion of the various costs of capital structure theories so far put forth.

1.1 COST OF CAPITAL

Usually the cost of debt is lower than the cost of equity. This is so because debt is a fixed
obligation while equity is not. However, firms cannot operate on debts alone since this will
subsequently increase the risk of bankruptcy (that is the firm being unable to meet its fixed
obligations). This risk of bankruptcy is also associated with the stability of sales and earnings. A
firm with relatively unstable earnings will be reluctant to adopt a high degree of leverage since
conceivably it might be unable to meet its fixed obligations at all.

Note: Financial leverage is the change in the EPS induced by the use of fixed securities to finance a
company's operation.

Cost of Debt:

The cost of debt to a firm can be given by the following formulae:

Kd = Annual interest charges

Market value of outstanding debt

Where Kd is the yield of the company's debts. The market value of outstanding debt will therefore
be given by the following formulae.

Market value of debt = Annual interest charges

Kd

Kd is the before tax cost of debt. However, the effective cost of debt is the after tax cost because
interest on debt is tax deductible. The effective cost of debt (Kb) therefore is

Kb = Kd (I - T)

Where Kb is the effective (after tax) cost

T is the corporate tax rate
 Cost of Preferred Stock

Preferred dividend is not tax deductible and therefore the tax adjustment is required when
considering the cost of preferred stock. The cost is therefore:

Kp = Dp
Pr

Where Dp is the annual preferred dividend

Pr is market price of preferred stocks (net of floatation costs)

Cost of Equity

Equity can be divided into two:

(a) Retained Earnings

(b) External Equity

Cost of Retained Earnings

The cost of retained earnings is the rate of return shareholders require on the firm's common stock. This is
an opportunity cost. The firm should earn on its retained earnings at least as much as its stockholders
themselves could earn on alternative investments of equivalent risk. We can use several methods to
estimate the cost of retained earnings. These are:

(a) The CAPM approach

CAPM has already been discussed in Lesson 2. Under this approach we assume that common
shareholders view only market risk as being relevant. The cost of retained earnings therefore can be
given as:

Kr = Kf + (Km - Kf) ßi

Where Kr is the cost of retained earnings

Km is the required rate of return on the market

Kf is the risk free rate
ßi is the stock's beta coefficient

If we can be able to estimate the risk free rate, the market rate and the stock's beta, then we
can easily estimate the cost of retained earnings (or the cost of external equity).

(b) The DCF Approach (Dividend Yield Model)

The second method is the discounted cashflow (DCF) method. The intrinsic value of a share is the
present value of its expected dividend stream:
 D1 D2 D∞ D1
Po = 1
+ 2
+ . .. + ∞ =
(1 + K r ) (1 + K r ) (1 + K r ) Kr - g

given the above equation

D1
Kr = +g
Po

Where g is a constant growth rate

D1 is the expected dividend
Po is the market value of shares

Cost of Newly issued external equity

When a firm sells shares in the market it incurs floatation costs. This causes a difference
between the cost of retained earnings and external equity.
If we use the DCF method, then
Where F is the floatation costs expressed as a percentage of market price of shares.
D1
Ke = +g
P o (1 - F )
Weighted Average Cost of Capital (WACC)

The WACC is the overall cost of using the various forms of fund. It can be given by:

WACC = Net operating Earnings (NOE)

Total Market Value of the firm

It can also be expressed as

Where
D
Ko is the weighted average cost of capital P E
Ko = K d (V ) ( ) ( )
+ Kp
V
+ Ke
V

Kd is the cost of debt

Kp is the cost of preference shares
Ke is the cost of equity

D, P, E are the proportions of debt, preferred stocks

V V V and equity in capital structure

For easy analysis we shall assume that the firm uses only debt and equity. The overall cost of
capital will therefore be given by:
 D E
Ko = K d ( ) ( )
V
Ke
V

= K e ¿( K e - K d )
D
¿
V

With this background we can look at what happens to K d, Ke and Ko as the degree of leverage
(denoted by D/E changes). This will be done by looking at the theories of capital structure.

2.0 CAPITAL STRUCTURE THEORIES

2.1 THE NET INCOME APPROACH (NI)

The essence of the NI approach is that the firm can increase its value or lower the overall cost of capital by
increasing the proportion of debt in the capital structure. The crucial assumption of this approach are:

(a) The use of debt does not change the risk perception of the investor. Thus K d and Ke remain constant
with changes in leverage.
(b) The debt capitalization rate is less than equity capitalization rate (i.e. Kd < Ke).

The implications of these assumptions are that with constant Kd and Ke, increased use of debt, by
magnifying the shareholders earnings will result in a higher value of the firm via higher value of equity.
The overall cost of capital will therefore decrease. If we consider the equation for the overall cost of
capital,

D
K o = K e - (K e - K d )
V

Ko decreases as D/V increases because K e and Kd are constant as per our assumptions and Kd is less
than Ke. This also implies that Ko will be equal to Ke if the firm does not employ any debt (i.e.
when D/V = 0) and that Ko will approach Kd as D/V approaches 1. This argument can be illustrated
graphically as follows.
2.2 NET OPERATING INCOME (NOI) APPROACH

The critical assumptions of this approach are:

i.The market capitalizes the value of the firm as a whole.

ii.Ko depends on the business risk. If the business risk is assumed to remain constant, then Ko will also
remain constant.
iii.The use of less costly debt increases the risk of the shareholders. This causes Ke to increase and thus
offset the advantage of cheaper debt.
iv.Kd is assumed to be constant.
v.Corporate income taxes are ignored.

The implications of the above assumptions are that the market value of the firm depends on the business
risk of the firm and is independent of the financial mix. This can be illustrated as follows:
2.3 TRADITIONAL APPROACH TO CAPITAL STRUCTURE
The traditional approach to the valuation and leverage assumes that there is an optimal capital
structure and that the firm can increase total value through the judicious use of leverage. It is a
compromise between the net income approach and the net operating income approach. It implies
that the cost of capital declines with increase in leverage (because debt capital is cheaper) within a
reasonable or acceptable limit of debts and then increases with increase in leverage.

The optimal capital structure is the point at which K o bottoms out. Therefore this approach implies
that the cost of capital is not independent of the capital structure of the firm and that there is an
optimal capital structure. Graphically this approach can be depicted as follows:
 The traditional approach has been criticized as follows:

(a) The market value of the firm depends on the net operating income and the risk attached to it,
but not how it is distributed;

(b) The approach implies that totality of risk incurred by all security holders of a firm can be
altered by changing the way this totality or risk is distributed among the various classes of
securities. In a perfect market this argument is not true.

The traditional approach however has been supported due to tax deductibility of interest charges
and market imperfections.

2.4 THE MODIGLIANI-MILLER (MM) HYPOTHESIS

The MM, in their first paper (in 1958) advocated that the relationship between leverage and the cost
of capital is explained by the net operating income approach. They argued that in the absence of
taxes, a firm's market value and the cost of capital remains invariant to the capital structure changes.
The arguments are based on the following assumptions:

(a) Capital markets are perfect and thus there are no transaction costs.
(b) The average expected future operating earnings of a firm are represented by subjective
random variables.
(c) Firms can be categorized into "equivalent return" classes and that all firms within a class
have the same degree of business risk.
(d) They also assumed that debt, both firm's and individual's is riskless.
(e) Corporate taxes are ignored.

Proposition I
The value of any firm is established by capitalizing its expected net operating income (If Tax = 0)

VL = VU = EBIT = EBIT
WACC KO

1. The value of a firm is independent of its leverage.

2. The weighted cost of capital to any firm, levered or not is

(a) Completely independent of its capital structure and

(b) Equal to the cost of equity to an unlevered firm in the same risk class.

Proposition II
The cost of equity to a levered firm is equal to

(a) The cost of equity to an unlevered firm in the same risk class plus
(b) A risk premium whose size depends on both the differential between the cost of equity and
debt to an unlevered firm and the amount of leverage used.

D
K el = K eu + Risk premium = K eu + ( K eu - K d )
E

As a firm's use of debt increases, its cost of equity also rises. The MM showed that a firm's value is
determined by its real assets, not the individual securities and thus capital structure decisions are
irrelevant as long as the firm's investment decisions are taken as given. This proposition allows for
complete separation of the investment and financial decisions. It implies that any firm could use the
capital budgeting procedures without worrying where the money for capital expenditure comes
from. The proposition is based on the fact that, if we have two streams of cash, A and B, then the
present value of A +B is equal to the present value of A plus the present value of B. This is the
principle of value additivity. The value of an asset is therefore preserved regardless of the nature of
the claim against it. The value of the firm therefore is determined by the assets of the firm and not
the proportion of debt and equity issued by the firm.

The MM further supported their arguments by the idea that investors are able to substitute personal
for corporate leverage, thereby replicating any capital structure the firm might undertake. They
used the arbitrage process to show that two firms alike in every respect except for capital structure
must have the same total value. If they don't, arbitrage process will drive the total value of the two
firms together.

Illustration
Assume that two firms the levered firm (L) and the unlevered firm (U) are identical in all important
respects except financial structure.

Firm L has Sh 4 million of 7.5% debt, while Firm U uses only equity. Both firms have EBIT of Sh
900,000 and the firms are in the same business risk class.

Initially assume that both firms have the same equity capitalization rate Ke(u) = Ke(L) = 10%.

Under these conditions the following situation will exist.

Firm U

Value of Firm U's Equity = EBIT - KD = 900,000 - 0

Ke 0.1

= Sh 9,000,000
Total market value = Du + Eu
= 0 + 9,000,000
= Sh 9,000,000

Firm L

Value of Firm L's Equity = EBIT - KdD = 900,000- 0.075(4,000,000)

Ke 0.10

= Sh 6m

Total market value = DL + EL

= 4m + 6m
= Sh 10,000,000

Thus the value of levered firm exceeds that of unlevered firm. The arbitrage process occurs as
shareholders of the levered firm sell their shares so as to invest in the unlevered firm.

Assume an investor owns 10% of L's stock. The market value of this investment is Sh 600,000.
The investor could sell this investment for Sh 600,000, borrow an amount equal to 10% of L's debt
(Sh 400,000) and buy 10% of U's shares for Sh 900,000. The investor would remain with Sh
100,000 which he can invest in 7.5% debt. His income position would be:

Sh Sh
Old income 10% of L's Sh 600,000 equity income 60,000
New income 10% of U's income 90,000
Less 7.5% interest on 400,000 (30,000) 60,000
Plus 7.5% interest on extra Sh 100,000 7,500
Total new investment income 67,500

The investor has therefore increased his income without increasing risk.

As investors sell L's shares, their prices would decrease while the purchaser of U will push its prices
upward until an equilibrium position is established.

Conclusion:

Taken together, the two MM propositions imply that the inclusion of more debt in the capital
structure will not increase the value of the firm, because the benefits of cheaper debt will be exactly
offset by an increase in the riskiness, and hence the cost of equity.

MM theory states that in a world without taxes, both the value of a firm and its overall cost of
capital are unaffected by its capital structure.
Illustration
Companies U and L are identical in every respect except that U is unlevered while L has
Sh 10 million of 5% bonds outstanding. Assume
(a) That all of the MM assumptions are met
(b) That there are no corporate or personal taxes
(c) That EBIT is Sh 2 million
(d) That the cost of equity to company U is 10%
Required:
i. Determine the value MM would estimate for each firm. (4
Marks)
ii. Determine the cost of equity for both firms. (3
Marks)
iii. Determine  the overall cost of capital for both firms. (3
Marks)
3. i. Value of U

Vu = EBIT = 2,000,000 = Sh 20 million

KOu 0.1

Value of L

VL = VU = 2,000,000 = Sh 20 million
0.1
 ii. Cost of Equity

Keu = 10% as given

KeL = Keu + (Keu - Kb) D/E

= 10% + (10% - 5%) 10/20

= 15.0%

iii. Overall Cost of Capital

KOU = Keu = 10%

KOL = KeL (E/V) + Kd (D/V)

= 15.0% (10/20) + 5% (10/20)

= 10% = KOU

2.5 CAPITAL STRUCTURE UNDER IMPERFECTIONS

The irrelevance of capital structure as discussed above rests on the absence of market imperfections.
However, with introduction of imperfections, it is possible for the value of the firm and its cost of
capital to change with changes in its capital structure. These imperfections are:

(a) Corporate Income Taxes

In a world with corporate taxes, where interest payments are tax deductible, it was recognized
by MM that the issuance of debt can enhance the value of the firm. This is because the levered
firm will pay less corporate taxes than the unlevered firm since the dividend payments are not
tax deductible. The total amount of payments available for both debt holders and stockholders
is greater if debt is employed. If the debt used is perpetual then the present value of the tax
shield is given by:

tc γ B
Present value of the tax shield = = tc B
γ

Where tc is the corporate tax rate

τ is the interest rate on debt
B is the market value of debt

The value of the firm will be:

Value of the firm = Value of Unlevered Firm + Value of the Tax Shield

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 From this formulae it can be seen that the greater the amount of debt, the greater the tax shield
and thus the greater the value of the firm, other things remaining constant.

MM therefore concluded that the optimal capital structure is one with maximum amount of
leverage.

(b) Personal Taxes

The above arguments may not hold in the presence of personal taxes as well.

It was shown by Merton Miller (M) in 1977 that when personal taxes are present, the present
value of the tax shield is given by:

( 1 -t c )¿(1 - t ps )
[
Present value of the tax shield = 1 -
(1 -t pd ) ]
¿ B

Where tc and B are as before, tpd is the personal income tax rate applicable to debt income, and
tps is the personal tax rate applicable to common stockholders income.

Miller argued that where tpd = tps the present value of the tax shield remains as before (t cB) and
under this condition the levered firm has a higher value than the unlevered firm. However, the
overall tax advantages associated with corporate debt is reduced by the fact that overall stock
income is taxed at a lower personal rate than is debt income. This is so because stock income
is divided into capital gain and dividend (capital gains tax has been suspended in Kenya).

Note that in a case where tc = tpd and tps = 0 then the tax shield will be equal to zero.

(c) Financial Distress and Agency Costs

Use of debt in the capital structure has a limit after which it becomes very hard to acquire more
debt. Furthermore, the probability of the firm failing increases with increase in the use of debt.
If such a situation would occur, then the firm would incur extra cost in the form of lawyers's
fee, accountants and other court fees which would absorb part of the firm's value. The process
of liquidation usually involves a lot of legal processes which result in the firm's loss of value.
In some cases managers in a bid to guard against losing their jobs may make poor decisions so
as to delay the process of bankruptcy. Such decisions may dilute the future value of the assets.
Therefore, the levered firm should consider the cost of bankruptcy and financial distress.

Agency cost is the cost incurred by one party to monitor the activities of another. Protective
covenants can be thought of as a way for the creditors to monitor the actions of stockholders, to
preclude the erosion in value of their interest and this reduces the value of the firm to its
shareholders. The value of the levered firm will therefore be:

VL = Vu + TcB – COD - AC

Where COD is the present value of expected financial distress costs and AC is the expected
value of agency costs.

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(d) Asymmetric Information Theory

In early 1960s, Prof. Donaldson (Harvard University) conducted an extensive survey of how
corporations actually establish their capital structure. Prof. Stewart Myers used the conclusion
of Donaldson to advance a theory on the asymmetry information.

Illustration

Assume that a firm has 10,000 shares outstanding at a current price of Sh 19 per share.
Managers have better information about the firms prospects than shareholders, and managers
believe that the "actual share" value based on existing assets is Sh 21 giving the equity a total
value of Sh 210,000. Suppose further that the firm identifies a new project which requires
external financing of Sh 100,000 and which has an estimated net present value (NPV) of Sh
5,000. This project is unanticipated by the firm's investors and hence Sh 5,000 NPV has not
been incorporated into the firm's Sh 190,000 market value of equity. The firm wants to sell
new equity to raise the Sh 100,000 to finance the project. Several possibilities are available.

1. Symmetric Information: First, consider a situation where management can convey its
information to the public and hence all investors do have the same information as
management regarding existing assets values. Under these conditions, the stock would
be selling at Sh 21 per share, so the firm would have to sell 100,000/21 = 4,762 new
shares.

The new share price =210,000 + 100,000 + 5,000 = Sh 21.34

10,000 + 4,762

Both old and new shareholders would benefit.

2. Asymmetric Information: Assume that the firm's management can in no way inform
investors about the shares true value. In this situation, new shares would be sold for
only Sh 19 per share.

Page 13 of 21
 No. of new shares = 100,000 = 5,263 shares
19

New share price = New market value + New Money Raised + NPV
Original shares + New shares

= 210,000 + 100,000 + 5,000

10,000 + 5,263

= Sh 20.64

Under this condition the project should not be undertaken. This is because if the shares were not sold and
the information asymmetry was removed, then the share price would rise to Sh 21.

The sale of new shares at Sh 19 leads to a Sh 0.36 loss to the firm's existing shareholders and a Sh
1.64 gain to the new shareholders.

Page 14 of 21
 A more profitable project

Assume that the project had an NPV of Sh 20,000 and other conditions were unchanged.

New share prices = 210,000 + 100,000 + 20,000

10,000 + 5,263

= Sh 21.62

The firm should take the project. However, the new shareholders gain more than existing
shareholders. Sh 2.62 vs 0.62.

Dark Clouds on the Horizon

Suppose that shareholders think the firm is worth Sh 19 per share but the firm's managers think

(a) That outsiders are entirely too optimistic about the firm's growth opportunities and
(b) That investors are not properly recognising profound legislation which will require large non
earning investment in pollution control equipment. Faced with these problems managers
conclude that the true value of the firm's stock is only Sh 17 per share.

Assume that the managers issue 10,000 new shares to raise Sh 190,000 to retire debt or support these
years capital budget.

New "true" value = Old `true' value + New Money

Original share + New shares

= 170,000 + 190,000
10,000 + 10,000

= Sh 18
Current shareholders will lose when the information is released but the sale of shares reduces the loss.

If debt was used

New share price = 210,000 + 5,000

10,000

= Sh 21.50

All the true value of firm's existing assets plus the NPV of the new project goes to the existing
shareholders.

3.1 FINANCIAL & OPERATIONAL GEARING

FINANCIAL GEARING
In financial management the term financial gearing (leverage) is used to describe the way in which
owners of the firm can use the assets of the firm to gear up the assets and earnings of the firm.
Employing debt allows the owner to control greater volume of assets than they could if they invested their
own money only. The higher the debt equity ratio, the higher the firm equity and therefore the firm level

Page 15 of 21
of financial risk. Financial risk occurs due to the higher proportion of financial obligations in the firms
cost structure. The degree to which the firm is financially geared can be measured by the degree of
financial gearing given by:

Degree of Financial Gearing (DFG) = (%  in EPS)

(%  in EBIT)

The degree of financial gearing indicates how sensitive a firm’s E PS is to changes in earnings before
changes in interest and taxes (EBIT).

ILLUSTRATION
The financial manager of ABC Ltd expects earnings before interest and taxes of £50,000 in the current
financial year and pays interest of 10% as long-term loan of £200 000. The company has 100 000
ordinary shares and the tax rate is 20%. The finance manager is currently examining 2 scenarios.
A case where EBIT is 25% less than expected.
A case where EBIT is 25% more than expected.

REQUIRED
Compute the EPS under the 3 cases and the degree of financial gearing for both scenario 1 and 2.

Solution:

Scenario 1 Base Case Scenario 2

(-25%) £ (+25%)
EBIT 37 500 50 000 62 500
Interest 20 000 20 000 20 000
EBT 17 500 30 000 42 500
Tax (20%) (3 500) (6 000) 8 500
EAT 14 000 24 000 34 000
EPS £0.14 £0.24 £0.34

DFG = % in EPS
% in EBIT

Scenario 1 DFG = (0.24 – 0.14) / 0.24 = 1.67

0.23

Scenario 2 DFG = (0.34 – 0.24) / 0.24 = 1.67

0.25
The degree of financial gearing can be calculated more easily using the following formulae.

DFG = EBIT
EBT

= 50 000 = 1.67
30 000

Note that this formulae should be used for the base case only.

Page 16 of 21
A degree of financial gearing greater than one indicates that the firm is financially geared. The higher the
ratio, the more vulnerable the firm’s earnings available to shareholders are to changes in firm’s EBIT.

Operating Gearing

Financial gearing is related to the proportion of fixed financial cost in the firm’s overall cost structure.
Operating gearing however relate to the proportion of fixed operating cost in the firm’s overall cost
structure. Operating gearing mainly considers the relationship between changes in EBIT and changes in
sales. The degree to which a firm is operationally geared can be measured as follows:

D.O.G. = % in EBIT
% in Sales

D.O.G. therefore measures the sensitivity or vulnerability of EBIT to changes in sales. It can also be used to
measure Business Risk. If D.O.G is more than one, then the business is operationally geared.
Illustration:
Assume that the finance manager of ABC Ltd expects to generate sales of £50 000 in the current financial
year. Analysis of the firms operating cost structure reveals that variable operating cost is 40% of sales
and fixed operating cost at £250 000.

The manager wishes to explore the effect of changes in sales and has developed 2 scenarios.

Sales revenue is 10% less than expected

Sales revenue is 10% greater than expected

Required:

Compute EBIT for each of the scenarios and the degree of operating gearing.

Scenario 1 Base Case Scenario 2

(-10%) ₤ (+10%)
Sales 450 000 500 000 550 000
Variable cost 180 000 200 000 220 000
Contribution 270 000 300 000 330 000
Fixed cost 250 000 250 000 250 000
20 000 50 000 80 000

D. O. G. = (50 000 – 20 000) / 50 000 =6

(500 000 – 450 000) / 500 000

For the Base Case the degree of operating gearing can be given by the following formulae:

D.O.G. = Contribution
EBIT

= 300 000
50 000

= 6
Total Gearing

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Its possible to obtain an assessment of the firms total gearing by combining its financial gearing and
operating gearing so that the degree of total gearing (D.T.G) is equal to degree of operating gearing
multiplied by degree of financial gearing.

D.T.G. = D.O.G. X D. F. G.

= % in EPS
% in sales

D.T.G. therefore measures the sensitivity (vulnerability) of EPS to changes in company’s sales.

ILLUSTRATION
Consider the ABC illustration and compute the degree of total gearing.

Solution:
Base case Scenario 2
£ +10%
Sales 500 000 550 000
Variable cost 200 000 220 000
Contribution 300 000 330 000
Fixed cost 250 000 250 000
EBIT 50 000 80 000
Interest 20 000 20 000
EBT 30 00 60 000
Less Tax(10%) 6 000 12 000
EAT 24 000 48 000
EPS 0.24 0.48

D.T.G = (0.48 – 0.24) / 0.24 = 10

(550 000 – 500 000) / 500 000)

For the base case,

D.T.G = Contribution
EBT

= 300 000 = 10
30 000

3.2 ADJUSTED PRESENT VALUE (APV)

It has been noted that the company’s gearing level has an implication for both the value of equity and the
overall cost of capital. The viability of an investment project would depend partly on how it is financed and
partly on how the method of financing affects the company’s gearing. Investment projects can be evaluated
using NPV method by discounting the cash flows at the projects overall cost of capital or the risk adjusted
discount rate. An alternative method of carrying out project appraisal is use of NPV method involving 2
stages:
Evaluate a project as if its an all equity financed to determine the base case NPV
Make adjustments to allow for the effect of the method of financing that has been
used

Page 18 of 21
 APV = Base case NPV + PV of financing effect

Illustration
Assume XYZ ltd is considering a project which costs sh.100 000 to be financed by 50% equity with a
cost of 21.6% and 50% debt with a pre-tax cost of 12%.
The financing method would maintain the company’s overall cost of capital to remain unchanged. The
project is estimated to generate cash flows of sh.36 000 p.a. before interest charges and corporate tax at
33%.

Required:
Evaluate the project using:
NPV method
APV method

Solution:
1 Ko = Kd (I – T) (B/V) + Ko (E/V)
= 0.12 (1 – 0.33) 0.5 + 0.216 (0.5)
= 14.82%
After tax cash flows = 36 000 (1 – 0.33) = 24120
NPV = (24120) -100 000
0.1482
= sh.62 753

Amounts of debt = 50% (162 753) = £81376.5

Amount of equity = 50% (162 753) = £81376.5

2. Kel = Keu + (1 – T) (Keu – Kd) B/E

0.216 = Keu + (1- 0.33) (Keu – 0.12) 0.5/0.5
Keu = 0.177485029

Step 1 Base Case NPV = 24120 – 100 000

0.177485029
= 35899
APV =Base case NPV + PV of the interest tax shield (tcB)
= 35899 + 0.33 (81376.5)
= sh.62753
Decision:
Accept because NPV > 0

Note:APV and NPV method produce the same conclusion since the capital structure remains constant.
However, the NPV and APV method will produce different results in cases where the financing method
used changes the firm’s capital structure.

Illustration:
Assumes in the above illustration that the entire project were to be financed by debt.

The APV would be:

APV = 35899 + 0.33 (100 000)

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 = sh.68 899
APV is a better method where initial capital is raised in such a way that it changes the capital structure
proportions. It can be used to evaluate the effect of the method of financing a project and therefore is
better than NPV.

However, APV has the following Limitations:

i. Computation of the cost of a no equity-financed company may not be easy.
ii. Identifying all costs associated with the method of financing would be difficult e.g. the transaction costs,
agency cost, etc.

QUESTIONS
QUESTION ONE
Company A and B are in the same risk class and are identical in every respect except that Company A is
geared while B is not. Company A has Sh 6 million in 5% bonds outstanding. Both companies earn 10%
before interest and taxes on their Sh 10 million total assets. Assume perfect capital markets, rational
investors, a tax rate of 60% and a capitalization rate of 10% for an all equity company.

Required:

(a) Compute the value of firms A and B using the net income (NI) approach and Net operating income
(NOI) approach.
(b) Using the NOI approach, calculate the after tax weighted average cost of capital for firms A and B.
Which of these firms has the optimal capital structure according to NOI approach? Why?
(c) According to the NOI approach, the values of firms A and B computed in (a) are not in equilibrium.
Assuming that you own 10% of A's shares, show the process which will give you the same amount of
income but at less cost. At what point would this process stop?

QUESTION TWO
A company's current EPS is KSh 12. The firm pays out 40% of its earnings as dividend and has a growth
rate of 6% p.a. which is expected to continue into perpetuity. The company has a beta value of 1.4 and the
risk free rate is 10%. The expected market return is 15%.

Required:

(a) Using CAPM, compute the expected return on the company's equity.
(b) What implications does CAPM bring if it is used to determine a firm's cost of equity?

QUESTION THREE
Companies U and L are identical in every respect except that U is unlevered while L has Sh 10 million of
5% bonds outstanding. Assume

(a) That all of the MM assumptions are met

(b) That there are no corporate or personal taxes
(c) That EBIT is Sh 2 million
(d) That the cost of equity to company U is 10%

Required:
i. Determine the value MM would estimate for each firm

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ii. Determine the cost of equity for both firms
iii. What is the overall cost of capital for both firms
iv. Suppose the value of U is Sh 20 million and that of L is Sh 22 million. Explain the arbitrage process
for a shareholder who owns 10% of company L's shares.

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