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Hi Tutor ,
This is question 4 from LSBF mock exam :
ATP plc has recently been listed on the London Stock Exchange. In the
previous month, the company announced profits before interest and taxation
of £0.5 million and the Board of Directors believes that this level of profits is
unlikely to change in the foreseeable future. The dividend policy of the
company is to distribute all available profits to shareholders. The company is
financed entirely by equity shares but the Board wishes to change its capital
structure by issuing £3 million 5% debentures at par and using the proceeds
to purchase and cancel some of the equity shares in issue.
DIP plc operates within the same industry as ATP plc and is considered to
have the same level of business risk. It has a capital structure of 70% equity
and 30% loan capital. The equity beta of DIP plc is 1.4 and the loan capital is
risk free. The after-tax, risk-free rate of return and returns to the market are
4% and 9% respectively.
The rate of corporation tax is 20%===========================================================================================
Could you please help me to understand how they have calculated the WACC and value of company using proposed structure ?To find value of geared company they have used the following formula :
V( geared ) = V ( Ungeared ) + Debt * tax = 4347826 + 3000000*0.2 = 4,947,826
WACC = keu ( 1 – DT/ E + D ) = 9.2 ( 1 – 600000/4947826 ) = 8.08
is there a different way to calculate the WACC ?
==============================================================================================
I was able to work out the Value of ungeared company as 4,347,826 and Asset beta = 1.043 , Keu = 9.2% , but struggling to work out the value of firm and WACC on using the proposed structure .Whatever happens you need to be able to calculate the total market value of the geared company (4947826) calculated using the fact that the MV geared = MV ungeared + t x MV debt.
Once you have done that, the alternative way would be to use the fact that if we know the total MV, and we know that the debt is 3M, then the equity must be the balance (1.947M).
The you could calculate the equity beta, then the cost of equity, and then use all of that to calculate the WACC.
(I do think that LSBF have gone a bit over the top here – certainly about six years ago this could have been asked, but I think it much less likely from the current examiner)
Do not ask for copyrighted material on this website – it is both unethical and illegal.
I would also like to know what is after tax risk free rate of return and market return 4% and 9% respectively ,I want to know what is this after tax risk free rate of return and market return
The more risky an investment is, the higher return that investors require.
One of the most fundamental areas of the exam is CAPM – the CAPM formula allows us to calculate the return required for any level of risk (measured by the beta).The benchmarks for doing this are the risk-free rate – the return that investments carrying no risk are giving (the closest approximation being government securities); and the market return – the average return being given by the stock market as a whole.
I really would suggest that you watch the lectures on CAPM – there will never be an exam that does not require knowledge of CAPM.
I know risk free rate and market return but I don’t know what is after tax risk free rate and market
For LSBF to say ‘after-tax’ risk free rate and market return is at best confusing and irrelevant, and at worse wrong.
If they mean after personal tax, then it is OK, but irrelevant – we always ignore personal tax. (The risk free rate is the actual return to the investor, which is after personal tax).
If they mean after company tax, then they are wrong. The risk free rate is the return to the investor, which is before company tax.
this is the best answer, and I got confident
thank you very MUCH JOHN MOFFAT
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