What will the WACC be after recapitalization?

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COMPREHENSIVE TUTORIAL – MGMT 3048

UNITS COVERED – 1 and 2

Maximum Marks: 50

Weightage in Coursework: 20%1

INSTRUCTIONS TO CANDIDATES

1. There are 2 sections in this tutorial.

2. Each section contains 3 questions.

3. All questions from all sections are compulsory

4. The use of a normal, scientific and a non-programmable financial calculator is

allowed.

5. Due date: October 8, 2021. No late submissions are allowed.

6. Your submission should include a student accountability statement.

7. Plagiarism in any form is a serious offense and applicable penalty will be applied as

per UWI plagiarism policy if any part of your work is plagiarized.

1 This tutorial is worth 20% weightage in your entire coursework. This means that if someone, for example, scores

35/50, their score out of 20 will be (35/45) x 20 = 14. Please be guided accordingly.

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SECTION 1 – (25 MARKS)

Question 1

Bloom Company Limited expects its EBIT to be $100,000 every year forever. The firm can

borrow at 9 percent. The firm currently has no debt, and its cost of equity is 18 percent. The

tax rate is 35 percent. The firm will borrow $80,000 and use the proceeds to repurchase

shares. What will the WACC be after recapitalization? (5 marks)

Question 2

A company is all equity financed with 18,000 shares outstanding and each share sells for

$22. The EBIT of the company is $50,000. The company is debating of converting into

a 40% debt capital structure, with 6% interest per annum. The cost of capital is currently

10%. Ignore taxes.

You are required to answer the following:

(a) What is the current market value of the company? (b) What is the market value of debt in the proposed debt capital structure? (c) How many shares must be repurchased in the proposed levered company? (d) What is the cost of equity in the levered company? (e) What is the cost of capital of the levered company?

(10 marks)

Question 3

Bucco Tours Ltd and Storebay Tours Ltd operate in the same geographical area and are close

competitors. They are simply mirror images of each other and their financial records reflect

the same as well in terms of an identical EBIT of $160,000. However, the fundamental

difference is just that while Bucco Tours is fully financed by equity, S t o r e b a y T o u r s

follows a D/E ratio of 1. Both firms have assets worth $800,000 each and a share price of

$25 each. The current market interest rate is 8% and both firms are enjoying a tax holiday

because of the government policy to promote the tourism sector.

Both Bucco Tours Ltd and Storebay Tours Ltd follow a 100% dividend payout policy.

As a young graduate, you are aware that the economy will bounce back in the coming year and

knowing that leverage magnifies gains in good times, you have decided to invest $50,000 in

Storebay Tours Ltd.

You are required to answer the following questions:

a) What is your proportional ownership in Storebay Tours Ltd.?

b) What is the total cash inflow and rate of return on your investment in Storebay Tours

Ltd.?

c) Using homemade leverage, how demonstrate how an investor with 150 shares in

Bucco Tours Ltd, the unlevered firm can enjoy the same payoff, i.e., total cash flows

as that a shareholder with 150 shares enjoy in Storebay Tours Ltd.

(10 marks)

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SECTION 2 – (25 MARKS)

Question 1

The National Pension Fund pays no taxes on its capital gains or on its dividend and interest

income. Would it be illogical for it to have low-dividend, high growth stocks in its portfolio?

Would it be illogical to have government bonds (which are safe but offer a low interest) in its

portfolio? Explain (200 words)

(10 marks)

Question 2

Salsa Inc. estimates that this year’s earnings will be $75 million. There are 12 million shares

outstanding at a price of $27.50 per share. Salsa had been following a 100% dividend payout

policy until now but would now like to shift to the Residual Dividend policy for this year.

Dividends from this year’s earnings are paid next year.

a) What is the EPS and DPS for Salsa under the 100% dividend payout policy?

b) If the planned capital outlay is for $72 million and the target capital structure is 1.5:1,

will Salsa Inc. be able to pay dividends as per the Residual Dividend Policy? If so, what

will be the dividend per share? Investors require a 22.72% rate of return. Ignore taxes.

c) If Salsa Inc. shifts from a 100% payout policy to the residual dividend policy, what

impact will this have on its stock price, assuming the firm earns 22.72% as its ROE?

Support your argument through relevant computations. Which argument of the

dividend policy decision would you have demonstrated through this computation?

(Assume constant growth rate stock valuation model for computing stock price)

(10 marks) Question 3

You own 1,000 shares of Hefty Inc. Hefty follows a constant dividend policy, implying that it

will pay the same dividend per share each year indefinitely. The dividend per share is $2.30

per year. You intend to invest in Hefty’s stock and hold it for 2 years. At the same time, you

would like to receive at least $17 per share as dividend in the second year. You wish to achieve

your goal by following the homemade dividends strategy in a world without taxes. Will you be

able to do so? Substantiate your answer through relevant computations. Investors require a

return of 15% on Hefty’s stock.

(5 marks)