Chapter 16 Capital Structure

1. Objectives

1.1 Describe the traditional view of capital structure and its assumptions.
1.2 Describe the views of M&M on capital structure, both without and with
corporate taxation, and their assumptions.
1.3 Identify a range of capital market imperfections and describe their impact on
the views of M&M on capital structure.
1.4 Explain the relevance of pecking order theory to the selection of sources of
finance.

2. The Traditional View of Capital Structure

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2.1 KEY POINT
Under the traditional theory of cost of capital, the cost declines initially
and then rises as gearing increases. The optimal capital structure will be
the point at which WACC is lowest.

2.2 The traditional view of capital structure is that there is an optimal capital
structure and the company can increase its total value by suitable use of
debt finance in its capital structure.

2.3 ASSUMPTIONS
The assumptions on which this theory is based are as follows:
(a) The company pays out all its earnings as dividends.
(b) The gearing of the company can be changed immediately by
issuing debt to repurchase shares, or by issuing shares to repurchase
debt. There are no transaction costs for issues.
(c) The earnings of the company are expected to remain constant in
perpetuity and all investors share the same expectations about
these future earnings.
(d) Business risk is also constant, regardless of how the company
invests its funds.
(e) Taxation, for the timing being, is ignored.

2.4 The traditional view is as follows:

(a) As the level of gearing increases, the cost of debt remains
unchanged up to a certain level of gearing. Beyond this level, the cost
of debt will increase.
(b) The cost of equity rises as the level of gearing increases and financial
risk increases. There is a non-linear relationship between the cost of
equity and gearing.
(c) The WACC does not remain constant, but rather falls initially as the
proportion of debt capital increases, and then begins to increase as the
rising cost of equity (and possibly of debt) becomes more significant.
(d) The optimum level of gearing is where the company’s WACC is
minimized.
2.5 The traditional view about the cost of capital is illustrated in the following
figure. It shows that the WACC will be minimized at a particular level of

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 gearing X.

Where Ke is the cost of equity in the geared company

Kd is the cost of debt
K0 is the weighted average cost of capital
2.6 Conclusion – there is an optimal level of gearing – point X. At point X the
overall return required by investors (debt and equity) is minimised. It follows
that at this point the combined market value of the firm’s debt and equity
securities will also be maximised.
2.7 Company should gear up until it reaches optimal point and then raise a mix of
finance to maintain this level of gearing. However, there is no method, apart
from trial and error, available to locate the optimal point.

3. The Net Operating Income (Modigliani-Miller (M&M)) View

of WACC

3.1 KEY POINT

Modigliani and Miller stated that, in the absence of tax, a company’s
capital structure would have no impact upon its WACC.

3.2 The net operating income approach takes a different view of the effect of
gearing on WACC. In their 1958 theory, M&M proposed that the total market

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 value of a company, in the absence of tax, will be determined only by two
factors:
(a) the total earnings of the company.
(b) the level of operating (business) risk attached to those earnings.
3.3 The total market value would be computed by discounting the total earnings at
a rate that is appropriate to the level of operating risk. This rate would
represent the WACC of the company.
3.4 Thus M&M concluded that the capital structure of a company would have
no effect on its overall value or WACC.

3.5 ASSUMPTIONS
M&M made various assumptions in arriving at this conclusion, including:
(a) A perfect capital market exists, in which investors have the same
information, upon which they act rationally, to arrive at the same
expectations about future earnings and risks.
(b) There are no tax or transaction costs.
(c) Debt is risk-free and freely available at the same cost to investors
and companies alike.

3.6 KEY POINT

If M&M theory holds, it implies:
(a) The cost of debt remains unchanged as the level of gearing
increases.
(b) The cost of equity rises in such a way as to keep the WACC
constant.

3.7 This would be represented on a graph as shown below.

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3.8 EXAMPLE 1
A company has $5,000 of debt at 10% interest, and earns $5,000 a year
before interest is paid. There are 2,250 issued shares, and the WACC is
20%.

The market value of the company should be as follows:

Earnings $5,000
WACC 0.2
$
Market value of the company ($5,000 ÷ 0.2) 25,000
Less: market value of debt (5,000)
Market value of equity 20,000

5,000  500 4,500

The cost of equity is therefore   22.5%
20,000 20,000

4,500 1
And the market value per share is   $8.89
2,250 0.225

Suppose that the level of gearing is increased by issuing $5,000 more of

debt at 10% interest to repurchase 562 shares (at a market value of $8.89 per
share) leaving 1,688 shares in issue.

The WACC will, according to the net operating income approach, remain
unchanged at 20%. The market value of the company should still therefore
be $25,000.
Earnings $5,000

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 WACC 0.2
$
Market value of the company ($5,000 ÷ 0.2) 25,000
Less: market value of debt (10,000)
Market value of equity 15,000

Annual dividends will now be $5,000 – $1,000 interest = $4,000.

4,000
The cost of equity has risen to  26.667% and the market value
15,000

4,000 1
per share is still:   $8.89
1,688 0.2667

Conclusion:
The level of gearing is a matter of indifference to an investor, because it
does not affect the market value of the company, nor of an individual share.
This is because as the level of gearing rises, so does the cost of equity in
such a way as to keep both the weighted average cost of capital and the
market value of the shares constant. Although, in our example, the dividend
per share rises from $2 to $2.37, the increase in the cost of equity is such
that the market value per share remains at $8.89.

4. M&M with Tax

4.1 In 1963, M&M modified their model to reflect the fact that the corporate tax
system gives tax relief on interest payments.
4.2 They admitted that tax relief on interest payments does lower the WACC. The
savings arising from tax relief on debt interest are the tax shield (稅盾). They
claimed that the WACC will continue to fall, up to gearing to 100%.
4.3 This suggests that companies should have a capital structure made up
entirely of debt.

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4.4 However, this does not happen in practice due to existence of other market
imperfections (市場的不完善) which undermine the tax advantages of debt
finance.

(A) The problems of high gearing

4.5 Bankruptcy risk – As gearing increases so does the possibility of bankruptcy.

If shareholders become concerned, this will increase the WACC of the
company and reduce the share price.
4.6 Agency costs: restrictive conditions – In order to safeguard their
investments, lenders/debentures holders often impose restrictive conditions in
the loan agreements that constrain management’s freedom of action, e.g.
restrictions:
(a) on the level of dividends
(b) on the level of additional debt that can be raised
(c) on management from disposing of any major fixed assets without the
debenture holders’ agreement.
4.7 Tax exhaustion – After a certain level of gearing, companies will discover
that they have no tax liability left against which to offset interest charges.
Kd (1 – t) simply becomes Kd.
4.8 Borrowing/debt capacity – High levels of gearing are unusual because
companies run out of suitable assets to offer as security against loans.
Companies with assets which have an active second-hand market, and with
low levels of depreciation such as property companies, have a high borrowing
capacity.
4.9 Difference risk tolerance levels between shareholders and directors –
Business failure can have a far greater impact on directors than on a well-
diversified investor. It may be argued that directors have a natural tendency to
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 be cautious about borrowing.
4.10 Restrictions in the articles of association may specify limits on the company’s
ability to borrow.
4.11 The cost of borrowing increases as gearing increases.

5. Pecking Order Theory (融資順位理論)

5.1 Pecking order theory has been developed as an alternative to traditional theory.
It states that firms will prefer retained earnings to any other source of finance,
and then will choose debt, and last of all equity. The order of preference will
be:
(a) Retained earnings
(b) Straight debt
(c) Convertible debt
(d) Preference shares
(e) Equity shares
5.2 Internally-generated funds – i.e. retained earnings
(a) Already have the funds.
(b) Do not have to spend any time persuading outside investors of the
merits of the project.
(c) No issue costs.
5.3 Debt
(a) The degree of questioning and publicity associated with debt is usually
significantly less than that associated with a share issue.
(b) Moderate issue costs.
5.4 New issue of equity
(a) Perception by stock markets that it is a possible sign of problems.
Extensive questioning and publicity associated with a share issue.
(b) Expensive issue costs.

(A) Asymmetric information

5.5 Myers has suggested asymmetric information as an explanation for the heavy
reliance on retentions. This may be a situation where managers, because of
their access to more information about the firm, know that the value of the
shares is greater than the current MV (based on the weak and semi-strong
market information).
5.6 In the case of a new project, managers' forecasts may be higher and more
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 realistic than that of the market. If new shares were issued in this situation,
there is a possibility that they would be issued at too low a price, thus
transferring wealth from existing shareholders to new shareholders. In these
circumstances there might be a natural preference for internally-generated
funds over new issues. If additional funds are required over and above
internally-generated funds, then debt would be the next alternative.
5.7 If management is averse to making equity issues when in possession of
favourable inside information, market participants might assume that
management will be more likely to favour new issues when they are in
possession of unfavourable inside information which leads to the suggestion
that new issues might be regarded as a signal of bad news! Managers may
therefore wish to rely primarily on internally-generated funds supplemented by
borrowing, with issues of new equity as a last resort.
5.8 Myers and Majluf (1984) demonstrated that with asymmetric information,
equity issues are interpreted by the market as bad news, since managers are
only motivated to make equity issues when shares are overpriced. Bennett
Stewart (1990) puts it differently: ‘Raising equity conveys doubt. Investors
suspect that management is attempting to shore up the firm’s financial
resources for rough times ahead by selling over-valued shares.’
5.9 Asquith and Mullins (1983) empirically observed that announcements of new
equity issues are greeted by sharp declines in stock prices. Thus, equity issues
are comparatively rare among large established companies.
5.10 Test your understanding 1
Below is a series of graphs. Identify those that reflect:
(a) the traditional view of capital structure
(b) M&M without tax
(c) M&M with tax.

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5.11 Test your understanding 2
Answer the following questions:
A If a company, in a perfect capital market with no taxes, incorporates
increasing amounts of debt into its capital structure without
changing its operating risk, what will the impact be on its WACC?
B According to M&M why will the cost of equity always rise as the
company gears up?
C In a perfect capital market but with taxes, two companies are
identical in all respects, apart from their levels of gearing. A has
only equity finance, B has 50% debt finance. Which firm would
M&M argue was worth more?
D In practice a firm which has exhausted retained earnings, is likely to
select what form of finance next?
6. CAPM and M&M Combined – Geared Betas

6.1 KEY POINT

When an investment has differing business and finance risks from the
existing business, geared betas may be used to obtain an appropriate
required return.

Geared betas are calculated by:

(a) Ungearing industry betas
(b) Converting ungeared betas back into a geared beta that reflects the
company’s own gearing ratio

6.2 The gearing of a company will affect the risk of its equity. If a company is
geared and its financial risk is therefore higher than the risk of an all-equity

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 company, then the β value of the geared company’s equity will be higher than
theβ value of a similar ungeared company’s equity.
6.3 The CAPM is consistent with the propositions of M&M. M&M argue that as
gearing rises, the cost of equity rises to compensate shareholders for the extra
financial risk of investing in a geared company. This financial risk is an aspect
of systematic risk, and ought to be reflected in a company’s beta factor.

(A) Geared betas and ungeared betas

6.4 The connection between M&M theory and the CAPM means that it is possible
to establish a mathematical relationship between the β value of an ungeared
company and theβ value of a similar, but geared, company. Theβ value of a
geared company will be higher than theβ value of a company identical in every
respect except that it is all-equity financed. This is because of the extra
financial risk. The mathematical relationship between “ungeared” (or asset)
and “geared” betas is as follows.

 Ve   Vd (1  T ) 
a   e    d 
 Ve  Vd (1  T )    Ve  Vd (1  T )  

Where  a is the asset or ungeared beta

 e is the equity or geared beta
 d is the beta factor of debt in the geared company
Vd is the market value of the debt capital in the geared company
Ve is the market value of the equity capital in the geared company
T is the rate of corporate tax
6.5 Debt is often assumed to be risk-free and its beta is then taken as zero, in
which case the formula above reduces to the following form.

Ve Ve
a  g  or, without tax,  a   g 
Ve  Vd (1  T ) Ve  V d

6.6 EXAMPLE 2
Two companies are identical in every respect except for their capital
structure. Their market values are in equilibrium, as follows.
Geared Ungeared

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 $000 $000
Annual profit before interest and tax 1,000 1,000
Less: Interest (4,000 x 8%) 320 0
680 1,000
Less: Tax @30% 204 300
Profit after tax = dividends 476 700

Market value of equity 3,900 6,600

Market value of debt 4,180 0
Total market value of company 8,080 6,600

The total value of Geared is higher than the total value of Ungeared, which
is consistent with M&M.

All profits after tax are paid out as dividends, and so there is no dividend
growth. The beta value of Ungeared has been calculated as 1.0. The debt
capital of Geared can be regarded as risk-free.

Calculate:

(a) The cost of equity in Geared.

(b) The market return Rm.
(c) The beta value of Geared.

Solution:
(a) Since its market value (MV) is in equilibrium, the cost of equity in
Geared can be calculated as:
D 476
  12.20%
MV 3,900

(b) The beta value of Ungeared is 1.0, which means that the expected
returns from Ungeared are exactly the same as the market returns,
and Rm = 700/6,600 = 10.6%
V  Vd (1  T ) 3,900  (4,180  0.70)
(c) g  a  e  1.0   1.75
Ve 3,900
The beta of Geared, as we would expect, is higher than the beta of
Ungeared.

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(B) Using the geared and ungeared beta formula to estimate a beta factor

6.7 Another way of estimating a beta factor for a company’s equity is to use data
about the returns of other quoted companies which have similar operating
characteristics: that is, to use the beta values of other companies’ equity to
estimate a beta value for the company under consideration.
6.8 The beta values estimated for the firm under consideration must be adjusted
to allow for differences in gearing from the firms whose equity beta values
are known. The formula for geared and ungeared beta values can be applied.
6.9 If a company plans to invest in a project which involves diversification into a
new business, the investment will involve a different level of systematic risk
from that applying to the company’s existing business.
6.10 A discount rate should be calculated which is specific to the project, and
which takes account of both the project’s systematic risk and the company’s
gearing level. The discount rate can be found using the CAPM.
Step 1 Get an estimate of the systematic risk characteristics of the project’s
operating cash flows by obtaining published beta values for
companies in the industry into which the company is planning to
diversify.
Step 2 Adjust these beta values to allow for the company’s capital gearing
level. This adjustment is done in two stages.
(a) Convert the beta values of other companies in the industry to
ungeared betas, using the formula:
Ve
a  e 
Ve  Vd (1  T )
(b) Having obtained an ungeared beta value  a , convert it back
to geared beta  e , which reflects the company’s own gearing
ratio, using the formula:
V  Vd (1  T )
e  a  e
Ve
Step 3 Having estimated a project-specific geared beta, use the CAPM to
estimate:
(a) A project-specific cost of equity, and
(b) A project-specific cost of capital, based on a weighting of this
cost of equity and the cost of the company’s debt capital.

6.11 EXAMPLE 3

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 A company’s debt : equity ratio, by market values, is 2 : 5. The corporate
debt, which is assumed to be risk-free, yields 11% before tax. The beta
value of the company’s equity is currently 1.1. The average returns on stock
market equity is 16%.

The company is now proposing to invest in a project which would involve

diversification into a new industry, and the following information is
available about this industry.

(a) Average beta coefficient of equity capital = 1.59

(b) Average debt : equity ratio in the industry = 1 : 2 (by market value)

The rate of corporation tax is 30%. What would be a suitable cost of capital
to apply to the project?

Solution:

Step 1 The beta value for the industry is 1.59.

Step 2 (a) Convert the geared beta value for the industry to an ungeared
beta for the industry.
2
 a  1.59   1.18
2  (1  0.7)
(b) Convert this ungeared industry beta back into a geared beta,
which reflects the company’s own gearing level of 2 : 5.
5  (2  0.7)
 e  1.18   1.51
5
Step 3 (a) This is a project-specific beta for the firm’s equity capital,
and so using the CAPM, we can estimate the project-specific
cost of equity as:
Keg = 11% + (16% – 11%) x 1.51 = 18.55%
(b) The project will presumably be financed in a gearing ratio of
2 : 5 debt to equity, and so the project-specific cost of capital
ought to be:
[5/7 x 18.55%] + [2/7 x 70% x 11%] = 15.45%

6.12 Weaknesses in the formula

(a) It is difficult to identify other firms with identical operating

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 characteristics.
(b) Estimates of beta values from share price information are not
wholly accurate. They are based on statistical analysis of historical
data, and as the previous example shows, estimates using one firm’s
data will differ from estimates using another firm’s data.
(c) There may be differences in beta values between firms caused by:
(i) Different cost structures (e,g, the ratio of fixed costs to variable
costs)
(ii) Size differences between firms
(iii) Debt capital not being risk-free
(d) If the firm for which an equity beta is being estimated has
opportunities for growth that are recognized by investors, and which
will affect its equity beta, estimates of the equity beta based on other
firm’s data will be inaccurate, because the opportunities for growth will
not be allowed for.

6.13 Test your understanding 3

Backwoods is a major international company with its head office in the UK,
wanting to raise $150 million to establish a new production plant in the
eastern region of Germany. Backwoods evaluates its investments using
NPV, but is not sure what cost of capital to use in the discounting process
for this project evaluation.

The company is also proposing to increase its equity finance in the near
future for UK expansion, resulting overall in little change in the company’s
market-weighted capital gearing.

The summarized financial data for the company before expansion are shown
below.

Income statement for the year ended 31 December 2008

$m
Revenue 1,984
Gross profit 432
Profit after tax 81
Dividends 37
Retained earnings 44

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 Balance sheet as at 31 December 2008
Non-current assets 846
Working capital 350
1,196
Medium term and long term loans (see note below) 210
986
Shareholders’ funds
Issued ordinary shares of $0.50 each nominal value 225
Reserves 761
986

Notes on borrowings

These include $75m 14% fixed rate bonds due to mature in five years time
and redeemable at par. The current market price of these bonds is $120.00
and they have an after-tax cost of debt of 9%. Other medium and long-term
loans are floating rate UK bank loans at LIBOR plus 1%, with an after-tax
cost of debt of 7%.

Company rate of tax may be assumed to be at the rate of 30%. The

company’s ordinary shares are currently trading at $3.76.

The equity beta of Backwoods is estimated to be 1.18. The systematic risk

of debt may be assumed to be zero. The risk free rate is 7.75% and market
return 14.5%.

The estimated equity beta of the main German competitor in the same
industry as the new proposed plant in the eastern region Germany is 1.5, and
the competitor’s capital gearing is 35% equity and 65% debt by book
values, and 60% equity and 40% debt by market values.

Required:

Estimate the cost of capital that the company should use as the discount rate
for its proposed investment in eastern company. State clearly any
assumptions that you make.

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 Examination Style Questions

Question 1
Droxfol Co is a listed company that plans to spend $10m on expanding its existing
business. It has been suggested that the money could be raised by issuing 9% loan
notes redeemable in ten years’ time. Current financial information on Droxfol Co is as
follows.

Income statement information for the last year

$000
Profit before interest and tax 7,000
Interest (500)
Profit before tax 6,500
Tax (1,950)
Profit for the period 4,550

Statement of financial position for the last year $000 $000

Non-current assets 20,000
Current assets 20,000
Total assets 40,000

Equity and liabilities

Ordinary shares, par value $1 5,000
Retained earnings 22,500
Total equity 27,500
10% loan notes 5,000
9% preference shares, par value $1 2,500
Total non-current liabilities 7,500
Current liabilities 5,000
Total equity and liabilities 40,000

The current ex div ordinary share price is $4.50 per share. An ordinary dividend of 35
cents per share has just been paid and dividends are expected to increase by 4% per
year for the foreseeable future. The current ex div preference share price is 76.2 cents.
The loan notes are secured on the existing non-current assets of Droxfol Co and are
redeemable at par in eight years’ time. They have a current ex interest market price of
$105 per $100 loan note. Droxfol Co pays tax on profits at an annual rate of 30%.

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The expansion of business is expected to increase profit before interest and tax by
12% in the first year. Droxfol Co has no overdraft.

Average sector ratios:

Financial gearing: 45% (prior charge capital divided by equity capital on a book value
basis)
Interest coverage ratio: 12 times

Required:

(a) Calculate the current weighted average cost of capital of Droxfol Co. (9 marks)
(b) Discuss whether financial management theory suggests that Droxfol Co can
reduce its weighted average cost of capital to a minimum level. (8 marks)
(c) Evaluate and comment on the effects, after one year, of the loan note issue and
the expansion of business on the following ratios:
(i) interest coverage ratio;
(ii) financial gearing;
(iii) earnings per share.
Assume that the dividend growth rate of 4% is unchanged. (8 marks)
(Total 25 marks)
(ACCA F9 Financial Management Pilot Paper 2008 Q1)

Question 2
DD Co has a dividend payout ratio of 40% and has maintained this payout ratio for
several years. The current dividend per share of the company is 50c per share and it
expects that its next dividend per share, payable in one year’s time, will be 52c per
share.

The capital structure of the company is as follows:

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Bond A will be redeemed at par in ten years’ time and pays annual interest of 9%. The
current ex interest market price of the bond is $95·08.

Bond B will be redeemed at par in four years’ time and pays annual interest of 8%.
The cost of debt of this bond is 7·82% per year. The current ex interest market price
of the bond is $102·01.

Bond A and Bond B were issued at the same time.

DD Co has an equity beta of 1·2. The risk-free rate of return is 4% per year and the
average return on the market of 11% per year. Ignore taxation.

Required:

(a) Calculate the cost of debt of Bond A. (3 marks)

(b) Discuss the reasons why different bonds of the same company might have
different costs of debt. (6 marks)
(c) Calculate the following values for DD Co:
(i) cost of equity, using the capital asset pricing model; (2 marks)
(ii) ex dividend share price, using the dividend growth model; (3 marks)
(iii) capital gearing (debt divided by debt plus equity) using market values;
and (2 marks)
(iv) market value weighted average cost of capital. (2 marks)
(d) Discuss whether a change in dividend policy will affect the share price of DD
Co. (7 marks)
(Total 25 marks)
(ACCA F9 Financial Management December 2009 Q2)

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Question 3
Crastlee Inc is evaluating two projects. The first involves a $4.725 million
expenditure on new machinery to expand the company’s existing operations in the
textile industry. The second is a diversification into the packaging industry, and will
cost $9.275 million.

Crastlee’s summarized balance sheet (statement of financial position) as at 31

December 2008, and those of Canall Inc and Sealalot plc, two quoted companies in
the packaging industry, are shown below:
Crestlee Canall Sealalot
$m $m $m
Non-current assets 96 42 76
Current assets 95 82 65
191 124 141

Ordinary shares1 15 10 30
Reserves 50 27 50
Medium and long-term loans2 56 15 13
Current liabilities 70 72 48
Total equity and liabilities 191 124 141

Ordinary share price (cents) 380 180 230

Loan stock price ($) 104 112 -
Equity beta 1.2 1.3 1.2

1 Crestlee and Sealalot 50 cents per value, Canall 25 cents per value.
2 Crestlee 12% loan stock 2012-2014, Canall 14% loan stock 2017, Sealalot
medium-term bank loan.

Crestlee proposes to finance the expansion of textile operations with a $4.725 million
11% loan stock issue, and the packaging investment with a $9.275 million rights issue
at a discount of 10% on the current market price. Issue costs may be ignored.

Crestlee’s managers are proposing to use a discount rate of 15% per year to evaluate
each of these projects.

The risk free of interest is estimated to be 6% per year and the market return 14% per
year. Corporate tax is at a rate of 33% per year.

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Required:

(a) Determine whether 15% per year is an appropriate discount rate to use for each
of these projects. Explain your answer and state clearly any assumptions that
you make. (19 marks)
(b) Crestlee’s marketing director suggests that it is incorrect to use the same
discount rate each year for the investment in packaging as the early stages of the
investment are more risky, and should be discount at a higher rate. Another
board member disagrees saying that more distant cash flows are riskier and
should be discounted at a higher rate. Discuss the validity of the views of each
of the directors. (6 marks)
(Total 25 marks)

Question 4
The managing director of Wemere, a medium-sized private company, wishes to
improve the company’s investment decision-making process by using the discounted
cash flow techniques. He is disappointed to learn that estimates of a company’s cost
of capital usually require information on share prices which, for a private company,
are not available. His deputy suggests that the cost of equity can be estimated by using
data for Folten Inc, a similar sized, quoted company in the same industry, and he has
produced two suggested discount rates for use in Wemere’s future investment
appraisal. Both of these estimates are in excess of 15% per year which the managing
director believes to be very high, especially as the company has just agreed a fixed
rate bank loan at 10% per year to finance a small expansion of existing operations. He
has checked the calculations, which are numerically correct, but wonders if there are
any errors of principle.

Estimate 1: capital asset pricing model

Data have been purchased from a leading business school:
Equity beta of Folten 1.4
Market return 14%
Treasury bill yield 6%
The cost of capital is 14% + (14% – 6%) x 1.4 = 25.2%

This rate must be adjusted to include inflation at the current level of 4%. The
recommended discount rate is 29.2%

Estimate 2: dividend valuation model

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 Average share price (cents) Dividend per share (cents)
2003 193 9.23
2004 109 10.06
2005 96 10.97
2006 116 11.95
2007 130 13.03

D1 14.2
The cost of capital is   11 .01%
P0  g 138  9
Where D1 = expected dividend
P0 = current market price
g = growth rate of dividend (%)
When inflation is included the discount rate is 15.01%

Other financial information on the two companies is presented below:

Wemere Folten
$000 $000
Non-current assets 7,200 7,600
Current assets 7,600 7,800
Total assets 14,800 15,400

Ordinary shares (25 cents) 2,000 1,800

Reserves 6,500 5,500
Term loans 2,400 4,400
Current liabilities 3,900 3,700
14,800 15,400

Notes:
(1) The current ex-div share price of Folten Inc is 138 cents.
(2) Wemere’s board of directors has recently rejected a take-over bid of $10.6
million.
(3) Corporate tax is at the rate of 33%.

Required:

(a) Explain any errors of principle that have been made in the two estimates of the
cost of capital and produce revised estimates using both of the methods. State
clearly any assumptions that you make. (14 marks)
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(b) Discuss which of your revised estimates Wemere should use as the discount rate
for capital investment appraisal. (4 marks)
(c) Discuss whether discounted cash flow techniques including discounted payback
are useful to small unlisted companies. (7 marks)
(Total 25 marks)

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