Tutorial 10 Answers

1. What are the main differences between debt and equity? What are hybrids? ANSWER: a. The main difference between debt and equity are: Debt has a maturity date (i.e. need to be re aid! whereas equity has no maturity. Debt in"o#"es ayment of interest to #enders whereas no fi$ed returns are %uaranteed to equity ro"iders. Equity ro"iders are the owners of the firm and a## rofits (after c#aims of other arties! be#on% to them. Equity ro"iders bear hi%her ris& than the debt ro"iders. 'rom the firm(s ers ecti"e) hi%her the debt com onent) more the financia# ris&. *nterest ayments (cost of debt! are ta$ deductib#e) but di"idend ayments (cost of equity! are not ta$ deductib#e. Equity is more cost#y than the debt. *n the case of inso#"ency) debt ro"iders come ahead of shareho#ders. b. +,ybrids( re resent financia# instruments (or sources of funds! which ha"e features of both debt and equity. -on"ertib#e bonds and reference shares are two o u#ar ty es of hybrid securities. 2. a. .resent an ar%ument in su ort of an /N-(s fa"orin% a debt0intensi"e ca ita# structure. b. .resent an ar%ument in su ort of an /N-(s fa"orin% an equity0intensi"e ca ita# structure. ANSWER: a. /N-s that are we##0di"ersified across countries wou#d ha"e somewhat stable cash flows and may therefore be ab#e to hand#e a hi%h #e"e# of debt. They may use substantia# forei%n debt financin% to reduce their subsidiary e$ osure to e$chan%e rate ris& and country ris&. b. /N-s that are hi%h#y e$ osed to e$chan%e rate mo"ements or ha"e subsidiaries #ocated in o#itica##y unstab#e countries may e$ erience "ery volatile cash flows. These /N-s cou#d not hand#e hi%h eriodic debt ayments and may be better off with an equity0 intensi"e ca ita# structure. [Note: basically it all comes down to how stable are your cashflows. If more stable, you can afford to issue more debt, which means you get to enjoy the lower (after-tax) cost of debt. If less stable, then you are forced to rely more on e uity, which has a higher (aftertax) cost. !ee" this basic rule in mind when loo#ing at the next uestion. $hat about hybrids% &y"ically they are used by com"anies to get a chea"er cost of ca"ital. 'or exam"le, con(ertible bonds allow a lower cost of debt, because they )sweeten* the deal for the bond in(estor by offering an embedded call o"tion on the stoc#. +reference shares on the other hand reduce the cost of e uity by offering a higher and more stable di(idend than ordinary (or common) shares. In return, "reference

shareholders usually gi(e u" additional claim on "rofits and,or other ownershi" rights such as (oting rights.3. E$ #ain how fo##owin% characteristics of /N-s can affect the cost of ca ita#. Si1e Access to internationa# ca ita# mar&ets *nternationa# di"ersification E$chan%e rate ris&. -ountry ris&.

ANSWER:

Size. 2ar%er and better &nown /N-s may recei"e referentia# treatment by creditors. Access to international capital markets. /N-s ha"e access to more sources of funds than domestic firms. To the e$tent that financia# mar&ets are se%mented) /N-s may be ab#e to obtain financin% from "arious sources at a #ower cost. International diversification. *f /N-s can achie"e more stab#e cash f#ows throu%h their internationa# di"ersification) their robabi#ity of ban&ru tcy is reduced. -reditors and shareho#ders may therefore acce t a #ower rate of return when ro"idin% funds to the /N-s) which ref#ects a #ower cost of ca ita# for /N-s. !chan"e rate risk. /N-s that are hi%h#y e$ osed to e$chan%e rate mo"ements may be more #i&e#y to e$ erience financia# rob#ems (if they do not hed%e the ris&!. Thus) they may incur a hi%her cost of ca ita#. #ountr$ risk. /N-s with subsidiaries in o#itica##y unstab#e countries may e$ erience "o#ati#e cash f#ows o"er time and be more susce tib#e to financia# rob#ems. Thus) they may incur a hi%her cost of ca ita#.

[Note: .asically, these factors all relate to how stable are the com"any*s cashflows. &he only exce"tion is the second item (access to international ca"ital mar#ets.%. E$ #ain why mana%ers of a who##y0owned subsidiary may be more #i&e#y to satisfy the shareho#ders of the /N-. ANSWER: /ana%ers of a who##y0owned subsidiary can more easi#y focus on the ob3ecti"e of satisfyin% the /N-s shareho#ders. *f the subsidiary is art#y0owned) this im #ies that there are minority shareho#ders who ha"e an interest in the subsidiary (4sua##y the arent firm wi## ho#d ma3ority interest!. *n this case) the mana%ers may attem t to satisfy both the ma3ority and minority shareho#ders. ,owe"er) they cannot satisfy both %rou s simu#taneous#y. Some decisions made to satisfy minority shareho#ders may ha"e ad"erse effect on ma3ority shareho#ders.
5

Note: / higher cost of debt ca"ital is re"resented by a higher cou"on (interest) rate and,or a lower "rice "aid by in(estors to buy the bond. / higher cost of e uity ca"ital is re"resented by a lower "rice "aid by in(estors for the share. 0ence there is an in(erse relationshi" between the re uired rate of return (ersus the "rice "aid by in(estors for the security (bond or share).

&. 2aSa##e -or . is a 4.S.0based /N- with subsidiaries in "arious #ess de"e#o ed countries where stoc& mar&ets are not we## estab#ished. ,ow can 2aSa##e sti## achie"e its '"lobal( tar"et capital structure of 67 ercent debt and 67 ercent equity) if it #ans to use on#y debt financin% for the subsidiaries in these countries? ANSWER: 2aSa##e -or oration can use most#y equity financin% for its 4.S. o erations. When conso#idated with the debt financin% of its subsidiaries) its 8%#oba#9 tar%et ca ita# structure is ba#anced. The hea"y em hasis on equity financin% in the 4.S. offsets the hea"y em hasis on debt financin% in the forei%n countries. ). E$ #ain why the cost of ca ita# for a 4.S.0based /N- with a #ar%e subsidiary in :ra1i# may be hi%her than for a 4.S.0based /N- in the same industry with a #ar%e subsidiary in ;a an. Assume that the subsidiary o erations for each /N- are financed with #oca# debt in the host country. ANSWER: The ris&0free interest rate is much hi%her in :ra1i# than in ;a an. *n addition) the ris& remium on the business in :ra1i# may be hi%her than the ris& remium on the business in ;a an. [Note: the cost of debt ca"ital (#d) is usually thought to consist of two com"onents 1 the ris#-free rate for that maturity, "lus the ris# "remium for that com"any, reflecting the creditworthiness of the com"any.*. A 4S based /N-) -har#eston -or . is considerin% estab#ishin% a subsidiary in either <ermany or the 4nited =in%dom. The subsidiary wi## be most#y financed with #oans from the #oca# ban&s in the host country chosen. -har#eston has determined that the re"enue %enerated from the :ritish subsidiary wi## be s#i%ht#y more fa"orab#e than the re"enue %enerated by the <erman subsidiary) e"en after considerin% ta$ and e$chan%e rate effects. The initia# out#ay wi## be the same) and both countries a ear to be o#itica##y stab#e. -har#eston decides to estab#ish the subsidiary in the 4nited =in%dom because of the re"enue ad"anta%e. Do you a%ree with its decision? E$ #ain. ANSWER: -har#eston ne%#ected the cost of financin% the subsidiary. *t may be more cost#y to finance a subsidiary in the 4nited =in%dom than a subsidiary in <ermany when usin% the #oca# debt of the host country as the rimary source of funds. When considerin% the cost of financin%) a subsidiary in the 4nited =in%dom cou#d be #ess fa"orab#e than a subsidiary in <ermany) based on the information ro"ided in this question. [Note: if you thin# bac# to last wee#*s ca"ital budgeting uestion, basically this uestion is saying that 2harleston is only considering the cashflow elements (re(enue, ex"enses, exchange rates and initial in(estment, but is neglecting to consider the cost of ca"ital (discount rate), which will also affect the N+3 of the in(estment.+. Recent#y) Wa#0/art estab#ished two retai# out#ets in the city of Shan1en) -hina) which has a o u#ation of >.? mi##ion. These out#ets are massi"e and contain roducts urchased #oca##y as we## as im orts. As Wa#0/art %enerates earnin%s beyond what it needs in Shan1en) it may remit those earnin%s bac& to the 4nited States. Wa#0/art is #i&e#y to bui#d additiona# out#ets in Shan1en or in other -hinese cities in the future.

a. E$ #ain how the Wa#0/art out#ets in -hina wou#d use the s ot mar&et in forei%n e$chan%e. ANSWER: The Wa#0/art stores in -hina need other currencies to buy roducts from other countries) and must con"ert the -hinese currency (yuan! into the other currencies in the s ot mar&et to urchase these roducts. They a#so cou#d use the s ot mar&et to con"ert e$cess earnin%s denominated in yuan into do##ars) which wou#d be remitted to the 4.S. arent. b. E$ #ain how Wa#0/art cou#d use the internationa# bond mar&et to finance the estab#ishment of new out#ets in forei%n mar&ets. ANSWER: Wa#0/art cou#d issue bonds in the Eurobond mar&et to %enerate funds needed to estab#ish new out#ets. The bonds may be denominated in the currency that is needed@ then) once the stores are estab#ished) some of the cash f#ows %enerated by those stores cou#d be used to ay interest on the bonds. ,. :#oomin%ton -o. is a #ar%e 4.S.0based /N- with #ar%e subsidiaries in <ermany. *t has issued stoc& in <ermany in order to estab#ish its business. *t cou#d ha"e issued stoc& in the 4.S. and then used the roceeds in order to su ort the %rowth in Euro e. What is a ossib#e ad"anta%e of issuin% the stoc& in <ermany to finance <erman o erations? A#so) why mi%ht the <erman in"estors refer to urchase the stoc& that was issued in <ermany rather than urchase the stoc& of :#oomin%ton on a 4.S. stoc& e$chan%e? ANSWER: :y issuin% stoc& in <ermany) :#oomin%ton can use the euro roceeds to su ort its %rowth in <ermany. *t can estab#ish a secondary mar&et in <ermany by #istin% the stoc& on an e$chan%e there) and this wi## ma&e it easier for it to en%a%e in a secondary stoc& offerin% there in the future. *f <erman in"estors can urchase the stoc& and se## the stoc& on a <erman stoc& e$chan%e) they wi## not ha"e to worry about e$chan%e rate ris&.

-roblems
1. An /N- has tota# assets of AB77 mi##ion and debt of AC7 mi##ion. The firm(s before0ta$ cost of debt is BC ercent) and its cost of financin% with equity is B6 ercent. The /N- has a cor orate ta$ rate of D7 ercent. What is this firm(s wei%hted a"era%e cost of ca ita#? ANSWER:
5 4 #c = # d (B t ! + # e 5 + 4 5+4 AC7 AF7 = BCE(B .D! + B6E AB77 AB77 = .7BDD + .BC = .B>DD = B>.DDE

2. Wi#ey) *nc.) an /N-) has a beta of B.>. The 4.S. stoc& mar&et is e$ ected to %enerate an annua# return of BB ercent. -urrent#y) Treasury bi##s yie#d C ercent. :ased on this information) what is Wi#ey(s estimated cost of equity? ANSWER:
# e = 6 f + . ( 6m 6 f ! = CE + B.>(BBE CE! = .B>? = B>.?E

[Note: &he mar#et ex"ected rate of return (6m) is the ex"ected return on the o(erall stoc# mar#et. &his is usually re"resented by a broad stoc# index. In the 78, this may be the 89+:;; stoc# index, for large com"anies, or an e(en broader index li#e the $ilshire :;;; stoc# index, which includes many more smaller com"anies as well in the index (see next uestion). &he ris#-free rate (6f) is the interest rate for an in(estment that is free of credit ris#, forex ris#, interest rate ris# and all other forms of ris#. In the 78 this is usually re"resented by 78 <o(ernment &-.ills, which are short-maturity debt issued by the 78 go(ernment. 8ometimes a uestion may gi(e you the )e uity ris# "remium* rather than the mar#et ex"ected rate of return. &he e uity ris# "remium is sim"ly = 6m 1 6f. If that is the case, then you do not need to subtract the ris#-free rate again. .e (ery (ery careful whether the uestion is gi(ing you the mar#et ex"ected rate of return or the e uity ris# "remium> 3. :#ues) *nc. is an /N- #ocated in the 4.S. :#ues wou#d #i&e to estimate its wei%hted a"era%e cost of ca ita#. Gn a"era%e) bonds issued by :#ues yie#d H ercent. -urrent#y) T0bi## rates are > ercent. 'urthermore) :#ues( stoc& has a beta of B.6) and the return on the Wi#shire 6777 stoc& inde$ is e$ ected to be B7 ercent. :#ues( tar%et ca ita# structure is >7 ercent debt and ?7 ercent equity. *f :#ues is in the >6 ercent ta$ brac&et) what is its wei%hted a"era%e cost of ca ita#? ANSWER: 'irst) estimate the cost of equity usin% the -A./:
# e = 6 f + . ( 6m 6 f ! = >E + B.6(B7E >E! = .B>6 = B>.6E

Ne$t) estimate the wei%hted a"era%e cost of ca ita#:

5 4 #c = # d (B t ! + # e 5 + 4 5 +4 = .>(HE!(B .>6! + .?(B>.6E! = .7B?66 + .HD6 = .BBCB = BB.CBE

%. Inte"ratin" #ost of #apital and #apital .ud"etin". Iy#on -o. is a 4.S. firm that ro"ides techno#o%y software for the %o"ernment of Sin%a ore. *t wi## be aid

SA?)777)777 at the end of each of the ne$t fi"e years. The entire amount of the ayment re resents earnin%s since Iy#on created the techno#o%y software years a%o. Iy#on is sub3ect to a >7 ercent cor orate income ta$ rate in the 4nited States. *ts other cash inf#ows (such as re"enue! are e$ ected to be offset by its other cash outf#ows (due to o eratin% e$ enses! each year) so its rofits on the Sin%a ore contract re resent its e$ ected annua# net cash f#ows. *ts financin% costs are not considered within its estimate of cash f#ows. The Sin%a ore do##ar (SA! is resent#y worth A.J7) and Iy#on uses that s ot e$chan%e rate as a forecast of future e$chan%e rates. The ris&0free interest rate in the 4nited States is J ercent whi#e the ris&0free interest rate in Sin%a ore is BD ercent. Iy#on(s ca ita# structure is J7 ercent debt and D7 ercent equity. Iy#on is char%ed an interest rate of BC ercent on its debt. Iy#on(s cost of equity is based on the -A./. *t e$ ects that the 4.S. annua# mar&et return wi## be BC ercent er year. *ts beta is B.6. Kuiso -o.) a 4.S. firm) wants to acquire Iy#on and offers Iy#on a rice of AB7)777)777. Iy#on(s owner must decide whether to se## the business at this rice and hires you to ma&e a recommendation. Estimate the N.L to Iy#on as a resu#t of se##in% the business) and ma&e a recommendation about whether Iy#on(s owner shou#d se## the business at the rice offered. ANSWER: Iy#on(s cost of debt M BCE (B N .>! M F.DE Iy#on(s cost of equity M JE O (BCE N JE! P B.6 M B6E Iy#on(s cost of ca ita# M J7E (F.DE! O D7E (B6E! M .767D O .7J M .BB7D or about BBE Iy#on(s annua# e$ ected before0ta$ A -' are SA?)777)777 P A.J7 or AD)C77)777 (year B06! Iy#on is ta$ed on these earnin%s) so its after0ta$ cash f#ows M AD)C77)777 P (B N .>! M AC)HD7)777 *f Iy#on di"ests) it %i"es u a fi"e0year annuity of AC)HD7)777. *ts cost of ca ita# M BBE) and the resent "a#ue interest factor of annuity (.L*'A! for 6 yrs at this rate is >.JH6H. .L of for%one cash f#ows M AC)HD7)777 P >.JH6H M AB7)FJ6)HDJ. This is more than Iy#on wou#d recei"e from se##in% the business) so it shou#d not se## the business.
[Note: &his is li#e last wee#*s ca"ital budgeting uestions, exce"t that instead of calculating N+3, instead you calculate the +3 of the future cashflows, and com"are that to the offer "rice by the "otential buyer. /lso be careful that this uestion assumes the 8inga"ore go(ernment does not charge cor"orate tax or any withholding tax on the 8inga"orean subsidiary*s earnings. &herefore, the only tax "aid is at the "arent com"any le(el, on the 785 earnings. /lso note that we use the 78 ris#-free rate and 78 mar#et ex"ected return, not the 8inga"ore one. &his in(estment is seen from the 78 "arent com"any*s "ers"ecti(e.-

&. -ricin" A/0s. Today) the stoc& rice of <ene"o -om any (based in Swit1er#and! is riced at S'F7 er share. The s ot rate of the Swiss franc (S'! is A.?7. Durin% the ne$t year) you e$ ect that the stoc& rice of <ene"o -om any wi## dec#ine by >E. Qou a#so e$ ect that the Swiss franc wi## de reciate a%ainst the 4.S. do##ar by FE durin% the ne$t year. Qou own American de ository recei ts (ADRs! that re resent <ene"o stoc&. Each ADR that you own re resents two shares of the stoc& traded on the Swiss stoc& e$chan%e. What is the estimated "a#ue of the ADR er share in one year? ANSWER: E$ ected "a#ue of Swiss stoc& in B year M S'F7 $ (B 0 .7>! M S'??.J. E$ ected "a#ue of Swiss franc in B year M A.?7 (B 0 .7F! M A7.JDD E$ ected "a#ue of ADR in B year M C $ S'??.J $ (A7.JDD er franc! M AHH.H6. [note: the uotation for the s"ot rate is 8'r as base currency, so it is ?! to use the e uation:

('-8),8 = x@
$here x@ is the "ercentage a""reciation,de"reciation of the base currency (8'r). -