Corporate Finance: Definition, Types, and Examples

Qn 1. 

	ABCDEF	WYZABC
EBIT	EUR 300,000	EUR 300,000
Interest	EUR 0	EUR 120,000
EBT	EUR 300,000	EUR 180,000
Tax (35%)	EUR 105,000	EUR 63,000
Profits	EUR 195,000	EUR 117,000
Equity	EUR 2,000,000	EUR 1,000,000
ROE	9.75%	11.7%

Workings: 

Interest expense (WYZABC) = 12% x EUR 1,000,000 = EUR 120,000 

Tax rate (ABCDEF) = 35% x EBT = 35% x EUR 300,000 = EUR 105,000 

Tax rate (WYZABC) = 35% x EBT = 35% x EUR 180,000= EUR 63,000 

Profits = EBT – Tax rate (35%) 

Equity = Total assets for ABCDEF and assets – WYZABC’s Debt 

Equity = EUR (2,000,000 – 1,000,000) = EUR 1,000,000 

(b) ROE = Profits / Equity 

ROE (ABCDE)= 195,000/2,000,000 x 100% = 9.75% 

ROE (WYZABC) = 117,000/1,000,000 x 100% = 11.7% 

(c) The illustrations show that ROE has an increasing tendency with financial leverage. 

(d) Business risk is in relation to the earnings of the firm before the interest effects and tax rates impacts. Any level of impact on the business sums to the risk- comprises of the market share, the prices of commodities and the growth rate of the business. On the contrary, the financial risk is based on the firm’s finances on debt and their leverage. It is based on the cash flow generation in order to meet their obligations. 

(e) Scenario 1: If EBIT falls to EUR 200,000 

	ABCDEF	WYZABC
EBIT	EUR 200,000	EUR 200,000
Interest	EUR 0	EUR 120,000
EBT	EUR 200,000	EUR 80,000
Tax (35%)	EUR 70,000	EUR 28,000
Profits	EUR 130,000	EUR 52,000
Equity	EUR 2,000,000	EUR 1,000,000
ROE	6.5%	5.2%

Workings: 

Interest expense (WYZABC) = 12% x EUR 1,000,000 = EUR 120,000 

Tax rate (ABCDEF) = 35% x EBT = 35% x EUR 200,000 = EUR 70,000 

Tax rate (WYZABC) = 35% x EBT = 35% x EUR 80,000= EUR 28,000 

Profits = EBT – Tax rate (35%) 

Equity = Total assets for ABCDEF and assets – WYZABC’s Debt 

Equity = EUR 2,000,000 – EUR 1,000,000 = EUR 1,000,000 

ROE = Profits / Equity 

ROE (ABCDE)= 130,000/2,000,000 x 100% = 6.5% 

ROE (WYZABC) = 52,000/1,000,000 x 100% = 5.2% 

Scenario 2: If EBIT falls to EUR 100,000 

	ABCDEF	WYZABC
EBIT	EUR 100,000	EUR 100,000
Interest	EUR 0	EUR 120,000
EBT	EUR 100,000	(EUR 20,000)
Tax (35%)	EUR 35,000	(EUR 7,000)
Profits	EUR 65,000	(EUR 27,000)
Equity	EUR 2,000,000	EUR 1,000,000
ROE	3.25%	2.7%

Workings: 

Interest expense (WYZABC) = 12% x EUR 1,000,000 = EUR 120,000 

Tax rate (ABCDEF) = 35% x EBT = 35% x EUR 100,000 = EUR 35,000 

Tax rate (WYZABC) = 35% x EBT = 35% x (EUR 20,000) = (EUR 7,000) 

Profits = EBT – Tax rate (35%) 

Equity = Total assets for ABCDEF and assets – WYZABC’s Debt 

Equity = EUR 2,000,000 – EUR 1,000,000 = EUR 1,000,000 

ROE = Profits / Equity 

ROE (ABCDE)= 65,000/2,000,000 x 100% = 3.25% 

ROE (WYZABC) = 27,000/1,000,000 x 100% = 2.7% 

From the above two scenarios, the ROE for firm ABCDE is greater than that of firm WYZABC. 

Qn 2. 

WACC stands for “Weighted Average Cost of Capital” meaning it is the cost of capital that is calculated and proportionately weighted. An increasing WACC shows valuation decrease and risk increment. 

(a)If the firm’s corporate tax increases – The result is a decrease in the cost of debts. Hence, the effect on the WACC is a decrease. For example, the case in Turkey whereby the corporate tax rates approached 22% from 20%. 

(b)If the Central Bank causes an increase in the risk-free rate- The impact is that there is an increase observation in the cost of debt. Therefore, an increase in the cost of equity, thus an increase in the WACC. The case can be illustrated with the Turkey case in the 2015 at 7.92% then a realization on an increase in 2018 at 11.44% rate. 

(c)If the Central Bank causes an increase in the risk- free rate- The impact is that there is a decrease in the cost of debt. Thus, a decrease in the cost of equity, therefore a decrease in the WACC. For example, the case of Turkey before the year, 2015. 

(d)If the firm’s corporate tax decreases – There is a response realized regarding cost of debt increasing as a result of the tax decreases. Meaning that the WACC increases. For example, the corporate tax rates for the US in 2018, January 1 st approached 21% from 35%. Hence, companies choose to use less debt as they know debts’ costs would increase. 

Qn 3. 

Net income before the process of repurchase  = (36 million x EUR 0.60) =	EUR 21.60 million
Interest on the debt  = EUR 45 million x 12%	EUR 5.40 million
Interest after tax  = EUR 5.4 million x (1-0.35) =	EUR 3.51 million
Number of the shares  = 36 million – 3.6 million	32.4 million
Repurchase net income  EUR 21.60 – EURO 3.51	EUR 18.09 million
EPS following repurchase  = 18.09/32.40 =	EUR 0.56

Qn 4. Main differences between Modigliani and Miller’s theory and the Traditional Approach theory 

The Traditional Approach theory is that WACC will at some time change with the capital structure changes also (Brusov et al., 2011). Therefore, there should be a capital structure that is optimal meaning that the WACC is at a point minimum and the market value at maximum. 

Secondly, the main difference concerns the benefit emanating from debt in the capital structure originating from the benefits of tax of the payments on interests. Since M & M assumes that there are no taxes, there is no cognition of the benefit whereas Traditional Approach theory, tax benefits have a recognition. 

Qn 5. Firm’s current weighted average cost of capital 

(a)WACC = equity cost x equity weight + debt cost x debt weight 

Equity cost = rate at risk free + beta x market premium 

= 8% x 1.15 x (5.5%) = 14.325% 

Equity weight = 1 / (1+0.25) = 0.80 

Debt weight = 0.25 / (1+0.25) = 0.20 

Debt = 0.25 x equity = 0.25 x (40 million shares * $20) 

= $200 million 

Debt increase = $20 million 

Interest on debt = $20 million / $200 million = 10% 

Taxable income = $130 million 

Tax = $52 million 

Tax rate = 52 / 130 = 0.4 = 40% 

Cost of debt = interest * (1-tax) = 10% * (1-0.40) = 6% 

Therefore, WACC = (14.325% *0.8) + (6%* 0.2) = 12.66% 

(b) Market capitalization = $20 * 40 million = $800 million 

Market’s value debt = $200 million at 25% 

New debt = $200 million + $200 million = $400 million 

New market capitalization = $800 million - $200 million = $600 million 

New debt equity rate = 400/600 = 0.67 

New WACC = (4/6 * 3.6%) + (2/6 * 10.6%) = 14.78% 

(c) New stock price = (Market capitalization + new debt) / $30 million 

= ($600 million + $400 million) / $30 million 

= $1,000 million / $30 million = $33.33 

Qn 6. 

(a)True – This is so because no investments would be carried out by equity investors when ROI is reduced compared to the cost of debts. Equally, equity holders are attached to debt holders. 

(b)False- because borrowing money that is more than what is required is improper funds utilization and that affects the profit and loss statements of the company. 

(c)True- Debt is relatively cheaper compared to equity because of limited risks and lender obligations. Moreover, there are attached to tax benefits. 

Qn 7. 

Long forward- is the security purchases’ contract at a predefined price called strike price and time. Hence, the payoff is the gap between the price on the said date and the strike price. 

Short forward- is the security sales’ contract at future price and dates. Hence, the payoff is the gap between the price on expiry and the strike price. 

Long put- is whereby a purchase of a contract is made to share selling at a future date. Payoff is therefore, strike price less the option premium less the price as at maturity. 

Short put- - is whereby a sale of a contract is made to share selling at a future date. Receiving of an option premium is made. Thus, the payoff is the strike price and the option premium if availed by the buyer. Notably, payments of option premiums are still received regardless any situation. 

Long call- is the process of purchasing a contract to purchase a share. Payments of option premium is made. No option premium is availed at maturity. Payoff is equal to price at maturity less the option premium less the strike price. Notably, payments of option premiums are still made regardless any situation. 

Short call- is the process of a contract sale to purchase a share. Thus, payoff is the strike price and the option premium. Notably, payments of option premiums are still made regardless any situation. 

Qn 8. Benefits of a right issue for your company 

The main benefits are that my company would have a savings of a significant sum of money such as the advertisement costs and the underwriting fees. Also, the company is controlled by the shareholders and there is also equal shares distribution in the company. 

Qn 9. Under the CAPM, 

Rs = Rf + Beta *(Rm-Rf) 

Where Rs is the security’s expected return, Rf is the 3%, the risk-free rate and the Rm-Rf is the difference for the expected market return 

Rm-Rf = 8% 

Beta = 8% 

Rs= 0.03 + 1.6 *0.08 = 0.158 

(a)Expected cost of using equity on CAPM = 15.8% 

(b) Using the dividend growth model 

P= D1 / (R-g2) 

Where Do=2, g2=0.04 

Therefore, D1=Do *(1+g2) 

D1= 2*(1+0.04) = 2.08 

P= D1/(R-g2) 

Where P=17.5 

17.5= 2.08/(R-0.04) 

(R-0.04) = 2.08/17.5 

R-0.04 =0.11886 

R= 0.11886+0.04 

R= 0.15886 

Hence, the expected cost of equity using the dividend growth model is (15.886%) 

(c)There is no difference at 3% risk free rate. 

When at 1%, Rf = 2% 

Rm-Rf = 9% 

Rs= 0.02+1.6*0.09 

Rs=16.4% 

Using CAPM, expected cost on equity is 16.4% 

Using the dividend growth model, expected cost on equity is 15.886% 

The difference = (16.4% -15.886%) = 0.514% 

Qn 10. Relationship between the firm cycle and dividends from a Free Cash Flow point of view. 

The firm cycle and dividends is attached to the fact that the firm achieves maturity then its ability is overtaken by the generation of cash. Hence, it finds profitable investments. On the relationship with the Free Cash Flow, the firm thus becomes optimal in the distribution of the cash in form of shareholders’ dividends 

Reference 

Brusov, P., Filatova, T., Orehova, N., & Brusova, N. (2011). Weighted average cost of capital in the theory of Modigliani–Miller, modified for a finite lifetime company. Applied Financial Economics, 21(11), 815-824. 

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