FINA6000 SOLUTIONS TO EXAM PRACTICE QUESTIONS

FINA6000 SOLUTIONS TO EXAM PRACTICE QUESTIONS

Question 1

You have $6 150 to deposit. Regency Bank offers 12 percent per year compounded monthly while King Bank offers 12 percent but will only compound annually. How much will your investment be worth in 20 years at each bank?

Effective interest rate for Regency Bank is EAR = [ 1 + r/m]^m -1 = [1 + 0.12/12]^12 -1 = 12.6825%

EAR for King Bank is 12%

Future Value of investment at Regency Bank ..FVn = PV x (1 +EAR)^ n = 6150 x (1.126825)^20

= 66 989.17

Future Value of investment at King Bank = 6150 x (1.12)^20 = 59 324.70

Question 2

You have decided that you want to be a millionaire when you retire in 45 years. If you can earn an annual return of 11 percent, how much do you have to invest today? What if you can earn 5.5 percent per annum?

Question requires you to calculate the Present value (PV)

At 11% per annum

FVn = PV x (1+ r)^n Millionaire means having a $1 000 000.

PV x (1.11)^45 = 1000 000 Thus PV = 1000 000/(1.11^45) = $9 129.90

At 5.5% per annum

FVn = PV x (1+ r)^n Millionaire means having a $1 000 000.

PV x (1.055)^45 = 1000 000 Thus PV = 1000 000/(1.055^45) = $89 875.09

Question 3

Beginning three months from now you want to be able to withdraw $2 500 each quarter from your bank account to cover college expenses over the next four years. If the account pays 0.38 percent interest per quarter, how much do you need to have in your bank account today to meet your expense needs over the next four years?

Better to draw a timeline to see the cashflows properly. Question requires to determine PV of an ordinary annuity

PV = C/r x [1 1/(1 + r )^n] = 2500/0.0038 x [ 1 1/(1.0038^16] = 2500 x 15.49477355 = 38 736.93

Question 4

You have recently finished your MBA at Torrens University Australia. Naturally, you must purchase a new BMW immediately. The car costs about $42 000. The bank quotes an interest rate of 15% APR for a 72-month loan with a 10% down payment. What will your monthly payment be? What is the effective interest rate on the loan?

Effective interest rate per month = APR/m = 15%/12 =1.25%

Deposit on car = 0.10 x 42 000 = 4 200

Amount of loan = 42 000 4 200 = 37 800.

Let C be monthly payment

Loan value = PV of monthly repayments at 1.25%

37 800 = C/r x [1 1/(1 + r )^n] = C/0.0125 x [1 1/(1.0125^72)] = C x 47.29247431

Therefore C = 799.28 Monthly repayment is $799.28.

Effective Annual Rate (EAR) = (1.0125)^12 -1 = 16.08%

Question 5

Lycan Inc. has 7 percent coupon bonds on the market that have 9 years left to maturity. The bonds make annual payments and have a par value of $1 000. If the yield to maturity (YTM) on these bonds is 8.4 percent per annum, what is the current bond price?

Amount of coupon (C) = 7% of face value = 0.07 x 1000 = 70

Value of bond = PV of Coupon payments + PV of Face Value

= C/r x [1 1/(1+r)^n] + Face Value/(1+r)^n]

= (70/0.084) x [1 - (1/(1.084^9)] + 1000/(1.084^9)

= 70 x 6.144301788 + 1000 x 0.48387865

= 430.1011252 + 483.8786498 = 913.98

Question 6

Yan Yan Corp. has a $2 000 par value bond outstanding with a coupon rate of 4.9 percent paid semi-annually and 13 years to maturity. The yield to maturity of the bond is 3.8 percent. What is the price of the bond?

Working in half years:

Coupon rate per period =4.9%/2 = 2.45% Amount of coupon = 0.0245 x 2 000 = 49

Yield per period = 3.8%/2 = 1.9%. N= 13 x 2 = 26

Value of bond = PV of Coupon payments + PV of Face Value

= (49/0.019 x [1 - (1/(1.019^26)] + 2000/(1.019^26)

=49 x 20.36762308 + 2000 x 0.613015161 = 998.0135 + 1226.0303

= 2224.04

Question 7

Discuss the concept of interest rate risk with regards to an investment in bonds. In your opinion, is a bond investor free from exposure to interest rate risk?

When market interest rates increase bond investors demand higher yields. However, the value of bonds decrease with high yields resulting in investors experience a capital loss. The opposite is true for a decrease in interest rates which results in bond values increasing, thus generating capital gains for the investors. The uncertainty surrounding the value of a bond due to changes in interest rates is termed price risk.

Bond investors are also exposed to reinvestment risk. The coupon payments that they are entitled to receive from the bond are fixed in amount. However, the investors have uncertainty about the rate of return they could get when they reinvest the coupon payments. This is due to possibilities of market interest rates changing. A decrease in rates implies getting a lower return on reinvestment. An increase in market interest rates would mean they get a higher return.

Combining the price risk plus the reinvestment risk is what makes the interest risk for a bond investor. Long-term bonds have more price risk than short-term bonds. Low coupon bonds have more price risk than high coupon bonds. Short-term bonds have more reinvestment rate risk than long-term bonds. High coupon bonds have more reinvestment risk than low coupon bonds.

Question 8

One of the ways of determining the value of equity is the discounted cash flow (DCF) approach which takes a number of different forms. The Dividend valuation models belong to the DCF techniques. Discuss the Dividend valuation approach explaining three different forms of the approach providing assumptions made in each.

Value of shares = PV of future cash flows generated by the shares. In the case of the Dividend Valuation model the cash flows are the dividends. The model takes different form depending on the nature of the growth in dividends.

Assuming zero growth in dividends

The cash flow are a perpetuity. The value of the share is:

Po = D/r where r = cost of equity

Assuming dividends grow at a constant growth rate indefinitely

P0 = D/(r g)

Dividend growing at differential growth rates e.g. growth g1 for some earlier years and then a constant growth rate of g2 from a future date until infinity.

Question 9

Small Fry Ltd produces a potato chip that looks and tastes like a french fry. It has just paid a dividend of $1.85. The dividend is expected to grow at the rate of 8% per annum until the fourth year. Thereafter the dividend is expected to grow at a constant rate of 3% per annum indefinitely. Using a cost of equity of 9.5% and the Dividend valuation model, calculate the value of the share of Small Fry Limited.

1.85 Years 1 2 3 4 g1 8%

Div2.00 2.16 2.33 2.52 g2 3%

DF 0.9132 0.834 0.7616 0.6955 Cost of equity 9.50%

PV 1.8264 1.80144 1.774528 1.75266 D5 2.60 19.4533

Value of Share 34.98

P4 = D5/(R - g1) 40.00

PV of P4 27.82297

Question 10

The ordinary shares of Madzika Limited paid $1.32 in dividends last year. Dividends are expected to grow at an annual rate of 8% for an indefinite number of years. If an investor requires a rate of 12%, what is the value of the companys share?

Value of share (P0) = D1/(r g) = D0 x (1 +g)/(r g) =1.32 x 1.08/(0.12 0.08) = $35.64

Question 11

Compare and contrast beta and standard deviation as measures of risk. Under which circumstances is standard deviation the appropriate measure of risk. When is beta the appropriate measure of risk?

Solution:

Beta () measures the systematic risk of security. It is the percentage change in the returns of a security as a result of a 1% change in the returns of the market portfolio. Systematic risk is that risk that cannot be removed by diversification of a portfolio. Its sources are changes in market factors such as changes in gross domestic product, interest rates, inflation and exchange rates. When the beta of a stock 1 it has the same risk as the market portfolio, when beta is greater than 1 it is more riskier than the market portfolio and when less than 1 it less riskier.

Standard deviation is the variability of returns and it applies to returns that are normally distributed. It measures total risk, which is a sum of systematic risk and unsystematic risk. Sources of unsystematic risk include company specific factors such as death of the managing director, a labour strike that disrupts company operations or an increase in the price of a major raw material in production. These factors can cause the return of a security to change but can be removed in a well-diversified portfolio.

If a portfolio is fully diversified it implies that there is no unsystematic risk therefore

beta is the appropriate measure of risk. In the case of a less diversified portfolio standard deviation would be the appropriate risk measure.

Question 12

What is (a) unsystematic risk and (b) systematic risk? Give an example of each type of risk.

Solution:

Unsystematic risk is the variability of returns of an asset due to changes in company specific factors. Sources of unsystematic risk are company specific, some examples are: death of the managing director, loss of a big market, labour strike at headquarters and fraud at the company. It is unsystematic risk which can be completely removed in a well- diversified portfolio of assets.

Systematic risk is the variability of a securitys returns due to changes in macroeconomic variables such as GDP, inflation, interest rate, exchange rate and the business cycle.

Question 13

Yun Fat Ltd is considering investing in an infrastructure project in northern China. Initial estimates of the projects returns for the next 5 years is as follows:

Year Estimated Return

1 -10%

2 18%

3 25%

4 40%

5 28%

Determine the arithmetic mean of the projects returns and the standard deviation of the returns.

Solution:

Ri Ri - E (R )[Ri - E (Ri)]^2

-10 -30.2 912.04

18 -2.2 4.84

25 4.8 23.04

40 19.8 392.04

28 7.8 60.84

101 1392.8

Arithmetic mean (AM) 20.2

Variance 348.2

Standard Deviation 18.66

Question 14

From the share price data below, compute the holding period returns for Iger and Eisner shares.

TIME PERIOD IGER ESINER

1 $6.00 $11.42

2 $6.66 $9.72

3 $9.08 $7.86

4 $14.58 $10.04

Return for each year: Rt = (Pt Pt-1)/Pt-1

FOR IGER: R1 = (6.66 6.00)/6.00 = 0.11 R2 = (9.08 6.66)/6.66 = 0.3634

R3 = (14.58 9.08)/9.08 = 0.6057

IGER Holding Period Return = (1 + R1)(1 + R2)(1 + R3) -1

= (1.11) x (1.3634)x (1.6057) 1 = 142.94%

EISNER Holding Period Return = (1 + R1)(1 +R2)(1 +R3) -1

= (0.8511) (0.8086) x (1.2774) 1 = - 12.09%

Question 15

Stock A, which has a beta of 1.2, is currently selling at $50 per share. On the basis of the companys strong growth, you expect the stock price to be $54 per share at the end of 1 year. The current risk-free rate is 7%, and the market return is 13%.

Calculate the stocks required rate of return. (5 marks)

Solution:

Expected return on stock E(Ri) = Rf + Beta x (Rm Rf) = 7% + 1.2 x (13% - 7%) = 14.2%

Actual return = capital gain yield = (54 50)/50

= 8%

The stock is overvalued since actual return is less than the expected return of 14.2% as predicted by CAPM.

Should you purchase the stock? (5 marks)

Solution:

Should not buy since the stock is overvalued. The actual return of 8% is less than the required rate of return of 14.2%.

Question 16

The returns on a Property portfolio are expected to be influenced by the possible states of the economy as follows:

State of Economy Probability of state occurring Projected Returns

Recession 25% -32%

Normal 63% 14%

Boom 12% 40%

Calculate the expected return of the portfolio and its standard deviation.

Solution:

Ri Probability (Pr) Ri x Pr [Ri - E (R )] [Ri - E (R )]^2 Pr x [Ri - E (R )]^2

-32 0.25 -8 -37.62 1415.2644 353.8161

14 0.63 8.82 8.38 70.2244 44.241372

40 0.12 4.8 34.38 1181.9844 141.838128

22 5.62 539.8956

Expected Return E (R )5.62

Variance 539.8956

Standard Deviation 23.24

Question 17

You own a portfolio consisting of the following shares:

Share % of portfolio Beta Expected Return

Share A 20% 1.00 16%

Share B 30% 0.85 14%

Share C 15% 1.2 20%

Share D 25% 0.60 12%

Share E 10% 1.60 24%

The risk-free rate is 6% and the expected return of the market portfolio is 15.5%

Calculate the expected return of the portfolio.

Solution:

E(Rp) = Wa x E(Ra) +Wb x E (Rb) +Wc x E (Rc) + Wd x E(Rd) + We x E(Re)

= 0.20 x 16 +0.30 x 14 +0.15 x 20 + 0.25 x 12 +0.10 x 24

= 3.2 + 4.2 +3 +3 +2.4 = 15.8%

Calculate the beta of the portfolio.

Solution:

Beta of portfolio = weighted average of the betas of the individual assets marking the portfolio

= 0.20 x 1.00 +0.30 x 0.85 +0.15 x 1.2 +0.25 x 0.60 + 0.10 x 1.60

= 0.2 + 0.255 + 0.18 +0.15 + 0.16 = 0.945

Question 18

Investor Becks Masawi would want to maximise his return and minimise his risk. He is considering investing in one of the following assets:

Asset Return (%) Standard Deviation (%)

G 18% 7%

H 12% 4%

Which asset should he invest in? Show the calculations

Solution:

Calculate Expected return per unit of risk:

Asset G: 18%/7% = 2.57

Asset H: 3.00

Since H has a higher Expected return per unit of risk, Becks Masawi should invest in H.

Question 19

Consider the following two mutually exclusive projects.

Year Cash Flow (D) Cash Flow (E)

0 -$235 000 -$47 000

1 $29 000 $28 700

2 $45 000 $19 900

3 $51 000 $17 300

4 $325 000 $16 200

If you require a return of 13% on your investment, which investment would you choose using the Net Present Value (NPV) criterion. Explain why.

Solution:

Question 20

What are the criticims of the payback period as a capital- budgeting technique?

Solution:

Payback period is how long it takes for a project to generate cash flows that cover the initial cash outlay or investment. The shorter the period the more preferred is the project.

Being able to recover the initial investment does not mean that beyond the payback period the project would generate cash flows that provide the required rate of return.

The Payback approach ignores cash flows that are made beyond the payback period. A project may have a longer payback period but once that has been achieved it can generate significant cash flows that could be beneficial to the firm.

The payback period technique ignores the time value of money cash flows are not discounted in its calculation.

What are its advantages? Why is it frequently used?

Solution:

Easy to calculate

Easy to understand, the quicker the initial investment is recovered the better

Provides an implicit way of determining how risky a project is, the one that has a smaller payback period is perceived to be less riskier than one with a longer payback period

Does the discounted payback method overcome the problems associated with the traditional payback method?

Solution:

The discounted payback period approach incorporates the time value of money when it is determined but still does not consider cash flows after the payback period. A project that could maximise sharehoder value may be rejected due to it having a longer discounted payback period and yet its cash flow after the discounted payback period are significant.

Question 21

Compare and contrast the Internal Rate of Return (IRR) and Net Present Value (NPV) techniques of evaluating projects, providing two advantages and two disadvantages of each.

Solution:

Net Present Value is the PV of future cash flows of a project less the initial outlay. It gives the extra value a project adds to firm value when taken up. A project is acceptable if its NPV is

greater than zero. If a choice of only one project is to be made among many, the one with the highest NPV is selected.

Internal rate of return (IRR) is the discount rate that makes NPV = 0. A project is acceptable if its internal rate of return is greater than the cost of capital to fund it. If project A has say an IRR of 12% and the required rate of return on the project (its cost of capital) is 8.5%, then the project is acceptable. If a choice of only one project is to be made then the project with the highest IRR which is greater than the cost of capital is chosen.

Net Present Value

Advantages Disadvantages

Shows the incremental value created should a project be taken on board Can be complex in calculating it

It is most superior of the techniques of capital budgeting IRR

Advantages Disadvantages

Easy to understand and compare with returns from other competing projects IRR more difficult to calculate. Projects with non - conventional cash flows has more than one IRR, making it difficult to decide which project is better.

IRR only gives a rate of return and not the amount of value created by the project. It ignores the scale of the projects. If one relies on it only, it may lead to a choosing a Mickey Mouse project with a high internal rate of return but small amount of value. NPV gives information on the value (wealth) to be created.

Does not distinguish between investing and borrowing

Question 22

Explain the term cost of capital from the perspective of a firm and from the point of view of investors in a firm.

Solution:

To investors in a firm such as ordinary shareholders, preference shareholders or debtholders, the cost of capital is the rate of return they require for investing in the firm. It should also reflect the risk they are taking. Since the equity holders have a residual claim on the cash flows of the firm and rank last they assume the most risk. That is why the cost of equity is higher than the cost of preference shares and the cost of debt capital.

From the perspective of the firm the cost of capital is the cost of raising funds from the various investors. A firm should in the minimum produce a return that should meet the required rate of return by the investors. If it fails to do that it means firm value is not being maximized. Some investors may pull out their funds and invest elsewhere where the return is higher.

Question 23

Discuss the two approaches used to determine the cost of equity.

Solution:

Students should discuss the CAPM model and the Constant Growth Dividend valuation model. They must explain the meaning of each of the inputs in each model.

CAPM:

Ke = Kf + Beta x (Km Kf)

Constant Growth Dividend Valuation Model:

Ke = (D1/P0) + g where:

D1 = projected dividend one year from now P0 = current ordinary share price

g = constant growth rate in dividends up to infinity. An analysis of the historical growth in last 5 years can be done and answer adjusted to reflect an assumed growth rate for the future.

Question 24

What are the disadvantages of the Dividend Growth Model in the calculation of the cost of equity?

Solution:

Using the historical growth rate in dividends to estimate future growth may be erroneous as history may not be repeated. There are possibilities of under or over-estimating.

The future prospects of a company are difficult to estimate especially in the long term

Usually different companies have different patterns of dividends growths. It is usually mature companies that no longer have viable investment opportunities that can approximate to steady growth in dividends. Young growing companies are likely to have erratic dividend patterns.

Question 25

When is the weighted average cost of capital (WACC) the appropriate discount rate to evaluate new projects?

Solution:

If the project under consideration is viewed as having a risk profile that is similar to the average projects of the firm then WACC is the appropriate discount rate. If the project is riskier then a discount rate higher than WACC must be used in determining the projects Net Present Value (NPV). If the risk of the project under conisderation is lower than the average projects of the firm then the discount rate to use must be lower than WACC.

Question 26

Dewyco has preference shares trading at $50 each and have a preference dividend of $4 per share. What is Dewycos cost of capital for preference shares?

Solution:

Cost of preference capital (Kp) = Dp/P0 = 4 x100/50 = 8%

Steady companys shares have a beta of 0.20. If the risk free rate is 6% and the market risk premium is 7%, what is an estimate of Steady Companys cost equity?

Solution:

Use CAPM formula to determine Ke.

E(Ke) = Kf + Beta x (Km Kf) = 6% + 0.20 x (market risk premium) = 6% +0.20 x 7% =7.4%

Please note that difference between market return and risk free rate is known as the market risk premium.

Note that when we refer to cost of capital we sometimes use K instead of R. Thus Ke = Re.

CAPM can thus be put down as Re = Rf + Beta x (Rm Rf)

HighGrowth Company has a share price of $20. The firm will pay a dividend next year of a $1.00 and its dividend is expected to grow at a rate of 4% per year thereafter. What is your estimate of HighGrowths cost of equity?

Solution:

Use the constant growth formula to estimate the cost of equity.

Ke = D1/P0 + g = (1/20) + 0.04 = 0.05 + 0.04 = 0.09 = 9%

Zeus Company has a debt with a yield to maturity of 7%, a cost of equity of 13% and a cost of preference shares of 9%. The market values of its debt, preference shares and equity are $10million, $3 million and $15 million respectively and its tax rate is 30%. What is the firms WACC?

Solution:

Source of capital Market Value Cost of capital (Ri) Weight (Wi)

Equity 15 13% 53.6%

Preference shares 3 9% 10.7%

Debt 10 7% 35.7%

28 100%

WACC = [(E / V) * RE] + [(D / V) * RD * (1 TC)] + [(P/V)* Rp]

= We x Re +Wd x Rd x (1 Tc) + Wp x Rp

= 0.536 x 13% + 0.357 x 7% x (1 - 0.30) + 0.107 x 9% = 6.968 + 1.7493 +0.963 = 9.68%

Question 27

Does the weighted average cost of capital (WACC) decrease with high levels of debt?

Solution:

The cost of debt is lower than cost of equity. According to Miller and Modigliani, in a pefect market where there are no transaction costs, no bankruptcy cossts, no taxes and information is equally accessible to all firms, the capital structure of a firm does not affect the WACC and thus firm value. An all equity firm has the same value as a firm 100% financed by debt or have a combination of debt and equity. Starting with an all equity firm, if some of the capital is replaced by debt, the cost of equity increases as introduction of debt makes equity more riskier since the firm has an obligation to meet debt payments. The impact of an increase in the cost of equity is compenasted by using debt which is cheaper. At whatever combination of debt and equity the overall effect would be a WACC that is the same as if the firm was all equity financed.

This changes in a world of taxes and of bankruptcy costs. As a firm uses more debt, due to the fact that debt is tax deductible, the cost of debt decreases resulting in a lower WACC. This increases firm value by the value of the tax shield of debt. However, as more debt is used costs of financial distress increase. Financial distress is a situation where the firm finds it hard to service its debt obligations. From the point the costs of financial distress overtake the value of the tax shield of debt, firm value starts to decrease. At that point WACC reaches its lowest value and begins to increase with higher debt levels.

Question 28

Discuss Miller and Modiglianis proposition which addresses the value of a levered firm in a world of taxes. What implications does it have on the use of debt in corporations?

Solution:

In a world of taxes, there is a tax advantage that accrues from having debt in the capital structure of a firm. Interest on debt is tax deductible. The firms corporate tax decreases due to the firm having a

tax relief from the interest it pays. This increases the net profit after tax. This benefit is known as the tax shield. If Kd is the cost of debt, Tc the corporation tax rate and Vd the value of debt, the value of the tax shield is Tc x Vd.

Miller and Modigliani states that the value of a firm with debt (a levered firm) is given by the following equation.

VL = Vu + Tc x Vd where:

VL = value of levered firm Vu = value of unlevered firm Tc x Vd = PV value of tax shield

Miller and Modigliani assume that firm value increases as more debt is used. The firm would have a maximum value if it is 100% financed by debt. However, this is not the case. In the real world firms operate with moderate levels of debt? Why is it like this? This is due to costs of financial distress. Financial distress is a situation when the firm is experiencing problems with servicing its financial obligations. At low levels of debt costs of financial distress are low and tax shield of debt is greater than the costs of financial distress. As more and more debt is added to the capital of the firm, the costs of financial distress increase until the point where the costs of financial distress are more than the tax benefits of debt. Extreme cases are when the firm is faced with bankruptcy. The company will be unable to operate efficiently, suppliers no longer keen to supply materials on credit, firm unable to access credit from the banks and management time consumed with liquidation procedures instead of generating cash flows.

Miller and Modigliani states that value of firm should be determined by:

Value of firm = Value of Unlevered firm + PV of Tax Shield PV of Costs of Financial Distress

From above equation firm value increases as long as the PV of Tax Shield is greater than PV of costs of financial distress. At very high levels of debt PV of costs of financial distress is greater than the PV of tax shield and firm value falls. The firm thus maximises value at the point the PV of Tax shield equals PV of costs of financial distress.

Question 29

Mhonderwa Ltd generates perpetual Free Cash Flow to the Firm (FCFF) of $39 million per year. The company is a all equity financed company where cost of euity is 9%.

Determine the value of the unlevered firm?

The firm is planning to take on debt to the tune of $51 million. Determine the value of the levered firm if the corporation tax rate is 30%?

Solution:

(a)Value of unlevered firm Vu = C/ r = 39/0.09 = $433.33m

(b)VL = Vu + Vd x Tc = 433.33m + 51m x 0.30 = $448.63m

Question 30

Explain how the level of gearing of a firm might be explained in terms of tax impacts and the costs of financial distress.

Solution:

Using debt in the capital structure of the firm benefits firm value due to the tax shield of debt (Vd x Tc). However, firms should be mindful of the fact that as the proportion of debt increases costs of financial distress can increase to the point that they overtake the value of the tax shield. This results in a net decrease in firm value. This mean that when the financial managers decide on the optimal capital structure to adopt for the firm, they should balance the marginal benefits of the tax shield and marginal costs of financial distress.

Question 31

Gibson Ltd expects perpetual earnings after tax of $2.5 million per year. If the cost of equity of the firm is 9%,

What is the value of the unlevered firm?

Solution:

Vu = C/ r = 2.5m/0.09 =$27.78m

If the firm becomes geared by taking debt with a market value of $58 million, what will the value of the levered firm be if the corporation tax rate is 30%?

VL = Vu + Vd x Tc = 27.78m + 58m x 0.30 = $45.18m

If debt is beneficial to firm value why is it that firms usually operate with moderate levels of debt rather than high levels?

Solution:

(This has been addressed with arguments given above). High level of debt are associated with high costs of financial distress which can offset the value of the tax shield of debt causing firm value to decrease.

Question 32

Discuss the pecking order and static trade theories of capital structure.

Solution:

Pecking Order Theory

Managers may prefer pecking order in raising long term capital for the firm: First is the use of retained earnings followed by safe debt such as from banks, then corporate debt and as a last resort equity financing.

The following are reasons for the pecking order:

Retained earnings are easily accessible and have no issue costs

Retained earnings do not involve dealing with or negotiating with third parties such as banks or investment bankers

When debt is compared to equity, issuing new debt is cheaper than equity. It is possible to raise small amounts of debt than equity.

Issuing equity is the last resort as issue costs are much higher than for debt. Equity involves costs of preparation of documentation such as prospectus, engagement of underwriters who will price and market the issue, and the continued requirement of disclosure by regulators after the issue.

Issuing of equity affects existing shareholding structure whereas issue of debt does not have ownership issues under normal circumstances.

If equity is issued through an initial public offering which is usually underpriced, existing shareholders lose out.

Trade off theory:

According to the trade off theory, the value of a levered firm equals the value of the firm without leverage plus the the present value of the tax savings from debt less the present value of the costs of financial distress. Firms should increase the amount debt until the point where the marginal benefits of debt (value of tax shield) equals the marginal costs of financial distress. Beyond that point firm value falls.

Question 33

Compare and contrast debt and equity as sources of long term capital.

Debt Equity

Not an ownership interest

Creditors do not have voting rights

Interest is considered a cost of doing business and is tax deductible

Creditors have legal recourse if interest or principal payments are missed

Excessive debt can lead to financial distress and bankruptcy

Ownership interest

Common stockholders vote for the board of directors and other issues

Dividends are not considered a cost of doing business and are not tax deductible

Dividends are not a liability of the firm, and stockholders have no legal recourse if dividends are not paid

An all-equity firm cannot go bankrupt

Initial public offerings (IPOs) are seen as one way of corporations getting better access to capital and increasing their liquidity. However, there are some disadvantages that arise through using this approach. Discuss four disadvantages of IPOs.

Students should define IPO

Disadvantages of public company listing (must explain a little)

Dilution of control of existing owners

Additional responsibilities of directors

Greater disclosure of information

Explicit costs

Insider trading implications

Firms can also issue preference shares as a source of long term capital. Discuss the advantages and disadvantages of preference shares.

Advantages

Disadvantages

No default risk with non-payment of dividends

No ownership dilution

Possible tax relief with franked dividends

Leverage effect on earnings per share (EPS)

Preference dividends are not tax deductible

Non-payment of a preference-share dividend can convey a negative signal to the market