FIN303-Financial Management

2.Holdings, an Asia-Pacific telecommunications company, has excess capital and is looking to make a regional telecommunications investment. S. Corp won the contract to advise T. Holdings on the potential of the investment, and allows T. Holdings to pay for its charges in annual installments, starting at $2 million for the next year, and increasing at 10% annually until the final installment in the fifth year.

 

The project under consideration entails an initial infrastructural investment of $600 million, and subsequent investments of the same amount every five years. These assets will be depreciated on a straight-line basis to a book value of zero five years from the purchase, but can be salvaged for approximately half the original investment amount. Revenue for the next year is projected to be $800 million, and is expected to grow at an annual rate of 20% for four years (i.e., years 2 through 5), after which revenues are expected to remain at that level indefinitely. Annual variable costs and year-end net working capital associated with the project are estimated to be 30% and 10% of annual revenue respectively, and fixed costs are estimated to be $80 million per year

Neither the debt nor equity of T. Holdings is traded, but S. Corp reckons they are worth $3 billion and $6 billion respectively. In the immediate future, T. Holdings intends to recapitalize by issuing equity to repay all of their outstanding debt. In addition, S. Corp looked into Good Inc. and Bad Inc.—the former is a conglomerate with businesses such as global telecommunications, food and beverage, and financial services, whereas the latter is a pure-play which focuses on developing their telecommunications business in the AsiaPacific. Also, S. Corp provides the following information on these entities:

(a) (i) Calculate and justify a suitable weighted average cost of capital based on T. Holdings’ existing capital structure.

(ii) Justify and calculate a suitable discount rate for the telecommunications project.

(b) (i) Compute operating cash flows for the first five years.

(ii) Compute changes in net working capital for the first five years.

(iii) Compute NPV based on cash flow from assets for the first five years.  (iv) Should T. Holdings accept the telecommunications project?

3.

Debt-free, Inc., an unlevered firm, is planning to use debt in its capital structure. The firm currently has 5,000 shares outstanding trading at $60 per share. The firm plans to sell 150 6% annual-coupon, 10-year bonds at their face values of $1,000 each and use the proceeds to repurchase some of its shares. When the bonds mature, Debt-free, Inc. plans to reissue new bonds to pay off the principal and to “roll over” its debt this way indefinitely. Assume the firm’s cost of debt does not change and there are no costs of financial distress. Earnings before interest and tax are expected to remain at $28,000 per year forever and the firm has a dividend policy of paying out all of its earnings. Maureen currently owns 100 shares of Debtfree, Inc

(a) (i) Calculate the total dollar annual dividend Maureen receives under the firm’s existing capital structure.

(ii) If the market learns of the capital restructuring before the exercise is completed, how many shares are repurchased under the planned capital restructuring?

(iii) Calculate total dollar annual dividend Maureen receives under the firm’s planned capital structure.

(iv) Debt-free, Inc. completes its planned capital restructuring but Maureen prefers the annual dividend payout of the unlevered firm. What is Maureen’s cash flow from homemade leverage by referencing the levered firm’s capital structure and assuming that she can borrow and lend at the same rate as the firm?

(v) Is capital structure irrelevant? Explain. (b) Redo part (a) assuming a one-tier corporate tax rate of 20% applies. Ignore personal income taxes.

a.i) Calculating the interest rate paid for the first month of 25^th year into the loan:

Particulars	Value
Rate	0.30%
Time	360
Amount	800,000
Monthly payment	$3,637.16

 

Particulars	Value
Rate	0.30%
Time	288
Amount	800,000
Monthly payment	$3,637.16
Loan outstanding after 24 years	$235,208.19
Interest paid in 1st month of 25th year	$705.62

a.ii) Calculating the total amount of interest paid for the loan:

Particulars	Value
Monthly payment	$       3,637.16
Time	360
Amount	$   800,000.00
Total interest paid	$   509,378.61

b) Interpreting the answers:

From the evaluation, it can be detected that the total interest paid during the period of 30 years is approximately 60% of the total loan amount. In addition, the major limitation is the term of the loan, while the refinancing is also conducted a draw back.

c) Calculating the present value of loan payments at a discount rate of 1.2%:

Particulars	Value
Rate	0.10%
Time	360
Monthly payment	$3,637.16
Present Value	$1,099,143.92

d) Interpreting the answer:

The major difference between the above solution is the difference in interest rate, which directly indicate that borrowing is much more benefits than to lend.

2.a.i) Calculating the justifiable weighted average cost of capital based on T. Holdings’ existing capital structure:

Particulars	Good Inc	Bad Inc
Beta	1.80	1.20
Market value of equity	$ 10,000,000,000	$ 4,000,000,000
Market value of debt	$ 20,000,000,000	$ 2,000,000,000
Total	$ 30,000,000,000	$ 6,000,000,000
Face value of debt	$ 22,000,000,000	$ 2,200,000,000
Years to debt maturity	15	5
Annual coupon rate	10%	8%
Risk free rate	5%	5%
Return on Market	15%	15%
cost of equity	23.00%	17.00%
WACC	13.00%	13.47%

The calculation is relevantly conducted in the above table, which depicts values of WACC for T. Holdings. The debt and equity combination of Bad Inc is supporting the current capital structure of T. Holdings. Hence, the WACC of 13.47% can be used for T. Holdings.

a.ii) Justifying and calculating the suitable discount rate for T. Holding:

Particulars	Bad Inc
Beta	1.20
Market value of equity	$ 4,000,000,000
Market value of debt	$ 2,000,000,000
Total	$ 6,000,000,000
Face value of debt	$ 2,200,000,000
Years to debt maturity	5
Annual coupon rate	8%
Risk free rate	5%
Return on Market	15%
cost of equity	17.00%
WACC	13.47%

The discount rate of 13.47% can be used for the computation of the NV analysis for the projects proposed to T. Holdings.

b.i) Computing the operating cash flow:

Particulars	1	2	3	4	5
Revenue	$         800,000,000	$ 960,000,000	$ 1,152,000,000	$ 1,382,400,000	$ 1,658,880,000
Variable cost	$         240,000,000	$ 288,000,000	$    345,600,000	$    414,720,000	$    497,664,000
Fixed cost	$           80,000,000	$   80,000,000	$      80,000,000	$      80,000,000	$      80,000,000
Payments	$             2,000,000	$     2,200,000	$        2,420,000	$        2,662,000	$        2,928,200
Salvage					$    300,000,000
Depreciation	$         120,000,000	$ 120,000,000	$    120,000,000	$    120,000,000	$    120,000,000
EBIT	$         358,000,000	$ 469,800,000	$    603,980,000	$    765,018,000	$    658,287,800
Tax	$           71,600,000	$   93,960,000	$    120,796,000	$    153,003,600	$    131,657,560
PAT	$         286,400,000	$ 375,840,000	$    483,184,000	$    612,014,400	$    526,630,240
Cash flow	$         406,400,000	$ 495,840,000	$    603,184,000	$    732,014,400	$    646,630,240

b.ii) Computing the net working capital for the first five years:

Particulars	1	2	3	4	5
Net working capital	$           80,000,000	$   96,000,000	$    115,200,000	$    138,240,000	$    165,888,000
Net Change in working capital		$   16,000,000	$      19,200,000	$      23,040,000	$      27,648,000

b.iii) Computing NPV of the project:

Particulars	0	1	2	3	4	5
Cash Flow	$        (680,000,000)	$ 406,400,000	$    479,840,000	$    583,984,000	$    708,974,400	$ 618,982,240
NPV	$ 1,207,448,769.49

b.iv) Recommending the actions to T. Holdings:

The calculation conducted in the above table directly indicates positive NPV values, which can allow T. Holding to improve its financial condition in future.

3.a.i) Calculating the divided of Maureen:

Particulars	Value
Earnings	$      28,000
Number of shares	5,000
Dividend per share	$          5.60
Maureen shares @100	$           560

a.ii) Calculating the share that will be repurchased:

Particulars	Value
150 Bonds @1000	$    150,000
Market value per share	$             60
Number of shares repurchased	2,500

a.iii) Calculating the divided of Maureen after the change in capital structure:

Particulars	Value
Earnings Before Interest	$      28,000
[email protected]%	$        9,000
Earnings	$      19,000
Number of shares	2,500
Dividend per share	$          7.60
Maureen shares @100	$           380

a.iv) Calculating different scenario for Maureen:

Particulars	Value
Unlevered firm	$           560
Levered firm	$           380
Investing in Bonds	$           360

a.v) Indicating whether the capital structure is irrelevant:

The new condition of Debt-free Inc will be problematic for the shareholders, as the debt-to-equity ratio is 1:1, which will reduce the shareholders’ value and raise debt payments.

b.i) Calculating the divided of Maureen:

Particulars	Value
Earnings	$   28,000
Tax	$     5,600
EAT	$   22,400
Number of shares	5,000
Dividend per share	$       4.48
Maureen shares @100	$        448

b.ii) Calculating the share that will be repurchased:

Particulars	Value
150 Bonds @1000	$ 150,000
Market value per share	$          60
Number of shares repurchased	2,500

b.iii) Calculating the divided of Maureen after the change in capital structure:

Particulars	Value
Earnings Before Interest	$   28,000
[email protected]%	$     9,000
Earnings	$   19,000
Tax	$     3,800
EAT	$   15,200
Number of shares	2,500
Dividend per share	$       6.08
Maureen shares @100	$        304

b.iv) Calculating different scenario for Maureen:

Particulars	Value
Unlevered firm	$        448
Levered firm	$        304
Investing in Bonds	$        360

b.v) Indicating whether the capital structure is irrelevant:

The debt combination of the firm is problematic, as it will reduce shareholders values and increase debt payments.

Bibliography:

Bekaert, G. and Hodrick, R., 2017. International financial management. Cambridge University Press.

DeAngelo, H. and Stulz, R.M., 2015. Liquid-claim production, risk management, and bank capital structure: Why high leverage is optimal for banks. Journal of Financial Economics, 116(2), pp.219-236.

Robb, A.M. and Robinson, D.T., 2014. The capital structure decisions of new firms. The Review of Financial Studies, 27(1), pp.153-179.

Zeitun, R. and Tian, G., 2014. Capital structure and corporate performance: evidence from Jordan.