Q3. Capital Structure Decisions Middle of Nowhere Limited.

Unit Price (each) $380 Fixed Operating Costs $1,300,000 Variable Costs (per unit) $220 Produced and Sold Each Year 45,000 Company is Financed Purely with Equity at the start: Balance Sheet (extract) Middle of Nowhere Ltd. Equity Issued Capital 7,000,000 Ordinary Shares fully paid Other Data MON Beta 1.34 Long Term Risk Free Discount Rate of NZ 6% Expected Future Market Risk Premium for NZ 4% Company Tax Rate 28% a) Business Risk Business Risk is measured by ROIC (return on invested capital) ROIC= NOPAT EBIT (1-T) Capital Capital

$37,380,000

EBIT sales revenues (yearly) less COGS Gross profit less operating expenses Operating Profit (EBIT) EBIT (1-T) Capital

$ 17,100,000 $ 9,900,000 $ 7,200,000 $ 1,300,000 $ 5,900,000 $ 4,248,000 $ 37,380,000

= 11.36%

ROIC = 11.36% The return on Invested Capital or ROIC is a measure of business risk as this combined two uncertain sources i.e. uncertainty about profits and uncertainty about cashflows. Because 11% is a very low measure, this proves that demand for the company's product is quite stable. In this instance the firm's input costs are not uncertain. Financial Risk Because financial risk is the additional amount of risk placed on common stockholders due to debt, financial risk will be absent until the managers choose to include debt in the capital structure mix. b) Levered beta, cost of equiry (rs), WACC Levered beta = Bu 1+(1-T) Wd Ws 1.34 [ 1+(1-.28) 0 ] 100 10 90 20 80

rs calculation is based on CAPM rs = Rrf + (rm Rrf) rs = 6 + 4 x 1.34 = 11.36%

WACC WACC = ((Wd x (rd x (1-T )) + (Ws x rs) i.e. 0.1 x (9 x (1-.28) + (0.9 x 11.78) = 11.25 % WACC which is the Optimal Capital Structure. Rd = cost of debt, which is the interest charges respective of the debt ratio present in the capital structure rd 6% 9% 11% 13% 15% 17% 19% Debt Financing 0% 10% 20% 30% 40% 50% 60% rd(1-T) 4% 6% 8% 9% 11% 12% 14% Debt proportion of Capital $ 0.00 $ 3,738,000 $ 7,476,000 $ 11,214,000 $ 14,952,000 $ 18,690,000 $ 22,428,000 Wd 0 0.1 0.2 0.3 0.4 0.5 0.6 Interest Charges $ 0.00 $ 336,420 $ 822,360 $ 1,457,820 $ 2,242,800 $ 3,177,300 $ 4,261,320 rs % 11.36 11.78 12.32 13.012 13.93 15.22 17.15 Ws 1 0.9 0.8 0.7 0.6 0.5 0.4 Equity Proportion of Cap $ 37,380,000 $ 33,642,000 $ 29,904,000 $ 26,166,000 $ 22,428,000 $ 18,690,000 $ 14,952,000

Capital $ 37,380,000 $ 37,380,000 $ 37,380,000 $ 37,380,000 $ 37,380,000 $ 37,380,000 $ 37,380,000

Cost of Debt 6% 9% 11% 13% 15% 17% 19%

Equity Financing 100% 90% 80% 70% 60% 50% 40%

Capital Structure Debt 0% 10% 20% 30% 40% 50% 60%

Equity 100% 90% 80% 70% 60% 50% 40%

Beta (b) 1.34 1.4472 1.5812 1.753 1.983 2.305 2.787

rs % 11.36 11.7888 12.3248 13.012 13.932 15.22 17.148

WACC % 11.36 11.25 11.44 11.92 12.68 13.73 15.07

Vop $ 37,394,366 $ 37,760,000 $ 37,132,867 $ 35,637,584 $ 33,501,577 $ 30,939,548 $ 28,188,454

Dollar amount of Debt $ $ 3,776,000 $ 7,426,573 $ 10,691,275 $ 13,400,631 $ 15,469,774 $ 16,913,072

c) Value of the company is determined by its value of operations which is the value of its present value of Free Cash Flows discounted at its WACC. Financial leverage i.e. using debt will have the effect of reducing the Vop, as increasing debt will have an increasing effect on the WACC, i.e. capital is more costly. A reduction in the Vop, will have the effect of lowering the firms value. Also an increasing amount of debt will increase the cost of stock, as stockholders feel less secure about their investments and thus require higher a return. FCF ( after tax operating profit amount of new investment in working capital and fixed assets necessary to sustain the business), increasing cashflows increases the value of the company as there is more money available to shareholders. Vop = EBIT (1-T) WACC From the above spread sheet, we can see that with increasing financial leverage the value of operations declines, therefore the value of the company declines. This also causes the cost of stock to increase. d) The money which is to be borrowed represents the proportion of debt in the capital

Debt Proportion of the Cap 0 0.1 0.2 0.3 0.4 0.5 0.6

Money to Borrow $0 $ 3,738,000 $ 7,476,000 $ 11,214,000 $ 14,952,000 $ 18,690,000 $ 22,428,000

Calculation .1*37,380,000 .2*37,380,000 .3*37,380,000 .4*37,380,000 .5*37,380,000 .6*37,380,000

e) Share Repurchase = Recapitalisation Company will issue new debt use proceeds from new debt to repurchase shares The money that the company borrows is used in this case. # Shares repurchased = Debt Repurchase price Capital Structure Debt 0 0.1 0.2 0.3 0.4 0.5 0.6 Estimated Market Value of Equity (S0) $ 37,394,366 $ 33,618,366 $ 30,333,427 $ 26,441,592 $ 22,236,953 $ 18,031,803 $ 14,026,476 Price per share $ 5.342 $ 4.803 $ 4.333 $ 3.777 $ 3.177 $ 2.576 $ 2.004 Dollar Value of Debt $ 0.00 $ 3,776,000 $ 7,426,573 $ 10,691,275 $ 13,400,631 $ 15,469,774 $ 16,913,072 0 786,237 1,713,819 2,830,349 4,218,402 6,005,413 8,440,574 No. Shares Repurchased Shares Outstanding 7,000,000 6,213,763 5,286,181 4,169,651 2,781,598 994,587 1,440,574 Share Price After Repurchase $ 5.342 $ 4.803 $ 4.333 $ 3.777 $ 3.177 $ 2.576 $ 2.004 EPS $ 0.61 $ 0.63 $ 0.65 $ 0.67 $ 0.72 $ 1.08 $ 0.01

Recapitalisation: issuing optimal amount of debt and then using the proceeds to repurchase stock. E.g of Calculation Estimated market value of equity = Vop Debt Vop = 37,394,366 Dollar amount of debt at each different capital structure ($ 0) at 0 debt At zero debt there is no debt, therefore the Vop is the estimated market value of equity. The share price changes with increasing financial leverage. Share price is caused to decline with increasing amounts of debt because the shares are more risky. The new share price is calculated by dividing the new estimated market value of equity by the number of shares outstanding. I.e. $37,394,366/ 7,000,000 = $5.34 (Initial share price) $ 33,618,366/ 7,000,000 = $4.80 and etc. Number of shares repurchased is initially zero, however this climbs as we are issuing more new debt. Share repurchase = cash raised by issuing debt /repurchase price, therefore at 10% debt, $ 3,776,000/4.80 = 786,237 shares repurchased. The number of shares remaining = Initially outstanding shares repurchased = 7,000,000 - 786,237 = 6,213,763 Outstanding This is repeated changing the numbers with increasing amounts of debt accordingly.

f)

EPS (earnings per share)

EPS = Net Income /Number of shares available in the market For 10% Debt EPS = Debt Financing 0% 10% 20% 30% 40% 50% 60% EBIT $ 5,900,000 $ 5,900,000 $ 5,900,000 $ 5,900,000 $ 5,900,000 $ 5,900,000 $ 5,900,000 Interest 0 $ 336,420 $ 822,360 $ 1,457,820 $ 2,242,800 $ 3,177,300 $ 4,261,320 Pre-Tax Income $ 5,900,000 $ 5,563,580 $ 5,077,640 $ 4,442,180 $ 3,657,200 $ 2,722,700 $ 1,638,680 Taxes (28%) $ 1,652,000 $ 1,652,000 $ 1,652,000 $ 1,652,000 $ 1,652,000 $ 1,652,000 $ 1,652,000 Net Income $ 4,248,000 $ 3,911,580 $ 3,425,640 $ 2,790,180 $ 2,005,200 $ 1,070,700 $ (13,320) ROE 11% 12% 11% 11% 9% 6% 0%

$ 3,911,580/6,213,763 = 0.61 and etc. g) Optimal Capital Structure Optimal Capital Structure is at 10% debt. At 10% Debt, the value of operations is at a maximum. WACC has the smallest value, this means it costs less to finance or raise capital for any project that is desired with 10% debt and 90% equity in this capital structure. Highest amount of Net Income is also raised, as well as NOPAT, which is the Free Cash Flows available for distribution to equity holders. At this capital structure, the cost of equity will be lowest, and shareholders will feel safest. This capital structure also supports the smallest beta roughly 1.45, which indicates smallest risk possible for this company.

h) TIE Time interest earned ratio = determined by EBIT/ Interest charges. This ratio measures the extent to which operating income can decline before the firm is unable to meet its annual interest costs.

Capital Structure Debt to Equity Ratio 0 0.11 0.25 0.43 0.67 1 1.5

EBIT $ 5,900,000 $ 5,900,000 $ 5,900,000 $ 5,900,000 $ 5,900,000 $ 5,900,000 $ 5,900,000

Interest -

TIE 17.538 7.174 4.047 2.631 1.857 1.385 Optimal Cap Structure

$ 336,420 $ 822,360 $ 1,457,820 $ 2,242,800 $ 3,177,300 $ 4,261,320

The more debt that is present within the capital structure, the smaller the time interest earned ratio, which indicates that operating income is less and less able to pay off the annual cost of interest. This is a big risk, as interest is a fixed cost on a debt and the smaller the TIE, the larger the risk, the larger the risk, the higher the risk of bankrupcy and other related issues i.e. stock price increasing, Cost of debt also increasing with increasing risk of bankruptcy as creditors will want to charge more interest on loans etc when the risk is too high.

i) Risk Premium to Shareholders Market risk premium = expected market return less risk free rate as in CAPM model rs = is the required return by investors who expect to get a return out of their investment Long Term Risk- Free Discount rate for NZ is 6% Capital Structure Debt to Equity Ratio 0 0.11 0.25 0.43 0.67 1 1.5

rs % 6 6.44 7 7.71 8.67 10 12

Premium 0 0.440 1 1.714 2.67 4 6

Calculations (6-6)=0 (6.44-6) = .44 (7-6) = 1 (7.71-6) (8.67-6) = 2.67 (10- 6) = 4 (12-6) = 6

Risk premium is directly related to the cost of equity because increasing cost of equity is directly due to increase in risk, therefore a higher risk premium is required to compensate the investors for the extra risk they are taking above the risk free rate.