UNIVERSITY OF KWAZULU-NATAL
SCHOOL OF ACCOUNTING, ECONOMICS AND FINANCE
FINANCE 321: 2024
TOPIC 3: PART 1: VALUATIONS WITH LEVERAGE
TUTORIAL 3.1
PART A
Indicate whether each of the following statements is True or false. Provide a reason
for your answer.
(a) According to the MMII proposition, the value of the levered firm is equal to the
value of the all-equity firm because the firm’s capital structure is insignificant.
(b) The APV is appropriate when the target debt-to-value ratio is time-varying.
(c) The cost of capital for discounting the depreciation tax shield using the APV
approach is the cost of equity.
(d) The WACC approach accounts for the tax benefit of debt financing by adding
the present value of the interest tax shield.
(e) The free cash flow to equity will decrease when a firm increases its net debt.
(f) The FTE approach is more useful in valuations of LBOs because the
approach does not depend on knowing the debt level.
(g) It is not possible to determine the value of a new project when the risk of the
project and the firm are not the same.
(h) The unlevered beta of a firm is always greater than the levered beta of the
firm.
(i) Flotation costs should be ignored when analysing the viability of a project
because they are not an actual cost of a project.
(j) A target debt-to-value of 40% implies that the target debt-to-equity is 40%.
PART B
1. DPZ enterprises has 250 000 shares outstanding. The firm has a debt-value ratio
of 55 percent and makes interest payments of R30,000 at the end of each year.
The cost of the firm’s levered equity is 22 percent. The CFO of DPZ estimates that
annual sales will be R1,500,000; annual cost of goods sold be R500 000; and
annual general and administrative costs will be R240,000. These cash flows are
expected to grow at a constant rate of 5% indefinitely. The corporate tax rate is 35
percent.
(a) Use the flow to equity approach to determine the value of the company’s
equity.
(b) Calculate the total value of the company and the value per share.
2. Swell Burritos is a popular Mexican restaurant, with a target debt-equity ratio of
0.40. If Swell Burritos were an all-equity company, it would have a beta of 1.3. The
expected return on the market portfolio is 14 percent, and Treasury bills currently
yield 6 percent. The company has one million bonds outstanding that mature in 10
years and have an 8 percent coupon rate (with coupons paid semi-annually). The
bonds currently sell at 98.5 percent of the par value. The firm’s current debt–
equity ratio is considered optimal. The corporate tax rate is 35 percent.
(a) Calculate the unlevered cost of capital.
(b) Calculate the levered cost of equity.
(c) Calculate the weighted average cost of capital
3. G&P is a multinational consumer goods corporation thinking of diversifying into
waste and recycling services. G&P plans to finance the new venture with D/V ratio
of 30%. One of the main competitors in the recycling services is Eco Recyclers
(ER). ER has bonds outstanding with a total market value of R45 million and a
yield to maturity of 6.5 percent. ER also has 3.2 million shares of common stock
outstanding, each selling for R30. The management of ER considers the firm’s
current debt–equity ratio optimal. ER’s beta is 1.15 and the expected return on the
market portfolio is 13%. The corporate tax rate is 35 percent, and Treasury bills
currently yield 3.4 percent. What is the appropriate discount rate for valuing the
new business venture?
4. The financial manager of Dube Enterprises, is considering a 15-year non-
amortizable loan of R3 500 000. Majola bank has reviewed Dube Enterprises
financial status and indicated that annual interest payments of 10% on the loan
must be made by Dube Enterprises. The company has a tax rate of 40%, and the
loan will not increase the risk of financial distress for the company
(a) Calculate the NPV of the financing side effects.
(b) If the loan requires floatation costs of 1.25% of the loan amount (Dube
Enterprises does have sufficient cash to pay these floatation costs upfront),
which will be amortized using a straight-line schedule over the 15-year life of
the loan, calculate the NPV of the financing side effects.
5. Eish-Kom is considering a R40 million project in its power systems division.
Damien Payal, the company’s chief financial officer, has evaluated the project and
determined that the project’s unlevered cash flows will be R3million in the first
year and are expected to grow at a constant rate of 3% per annum indefinitely. Mr
Payal has devised two possibilities for raising the initial investment: issuing 20-
year bonds or issuing equity. Eish-Kom’s pre-tax cost of debt is 7.2 percent, and
its cost of equity is 10.9 percent. The company’s target debt-to-equity ratio is 60
percent. The project has the same risk as Eish-Kom existing businesses, and it
will support the same amount of debt. Eish-Kom is in the 34 percent tax bracket.
Should Eish-Kom accept the project?
6. Mojito Mint Company has a debt-equity ratio of 0.45. The required return on the
company’s unlevered equity is 17 percent, and the pre-tax cost of the firm’s debt
is 9 percent. Sales revenue for the company is expected to remain stable
indefinitely at last year’s level of R23,500.000. Variable costs amount to 60
percent of sales. The tax rate is 28 percent, and the company distributes all its
earnings as dividends at the end of each year.
(a) If the company were financed entirely by equity, how much would it be worth?
(b) What is the required return on the firm’s levered equity?
(c) Use the weighted average cost of capital method to calculate the value of the
company. What is the value of the company’s equity? What is the value of
the company’s debt?
(d) Use the flow to equity method to calculate the value of the company’s equity?
7. Ndlovu Ltd. is considering an investment of R18 million that will be depreciated
according to the straight-line method over its three-year life. The project is
expected to generate earnings before taxes and depreciation of R6 million in year
1, R9 million in year 2 and R10 million in year 3. The company has a debt-equity
ratio of 30% and the cost of equity is 13 percent. The investment will not change
the risk level of the firm. SABA United bank has offered Ndlovu Ltd a three-year, 9
percent amortizing loan of R12 million after flotation fees. Flotation fees are 2% of
the gross proceeds and will be amortized over the three-year life of the loan.
Interest payments on the loan will be made annually and the company will make
equal payments of the principal payment at the end of each year. The loan will not
change the risk of financial distress of the company. The company’s corporate tax
rate is 32 percent and the rate of return on a risk free asset is 6 percent. Using the
adjusted present value method, determine whether the company should
undertake the project.
