The Board of Directors of Mintex Corporation have decided to raise £10m of debt finance for 10 years for a new project. The Finance Manager of the company has had detailed discussions with the company’s bankers and also a merchant banking firm which advises on raising finance from the markets for their operations.
(a) The following two alternatives have been identified:
(i) Finance from the bank: this will carry an interest rate of 8% per annum paid yearly.
(ii) Finance from a bond issue: this will have a face value of £100, carry a coupon of 6% and will be redeemed at its face value at maturity. Investors are prepared to pay £94 per bond. Issue costs to be deducted from the proceeds of a market issue, are estimated at 3%.
Assume that all interest is tax deductible, but not issue costs or front end expenses, or
capital payments. The rate of taxation is 40%.
Which source of finance is lower in cost? Show all workings. (25 marks)
Sunfun Limited is considering the acquisition of Verlan Limited. Both Sunfun and Verlan are all equity financed. The Management of Sunfun has estimated that if it takes over Verlan it can increase the pre tax cashflows of Verlan by $1m every year. The current market value of Sunfun is $65 million. It has 13 million shares outstanding.
The current market value of Verlan is $30 million and it has 3 million shares outstanding. Verlan has an equity beta of 0.6. The return on the market portfolio is 12%; the return on t-bills is 4%. Verlan pays tax at the rate of 25% on its profits. If the transaction completes, Sunfun will incur acquisition costs of $0.5m. Using theory as appropriate,
(i) What is the maximum price that Sunfun can pay as cash for a share of Verlan?
(ii) Is an exchange of 2.0 shares of Sunfun per share of Verlan, fair to Sunfun shareholders?
(iii) Critically evaluate all assumptions made in the calculations.
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Formulas for Corporate Finance
A. NPV and Internal Rate of Return (IRR)
NPV = ? CFt
( 1 + k) t
IRR= R1+ ((NPV(R1)/(NPV(R1)-NPV(R2))(R2-R1),
B. Portfolios (two asset case)
(i) E(R) = w1 R1 + w2R2,
(ii) ?p = ? (w12 ?12 + w2 ?22 + 2 w1w2?1?2 ?12 )
(iii) Covariance = ?12 ?1?2
(i) Capital Market Line equation: Rp = Rf + ( Rm-Rf ) ?p/?m
(ii) Security Market Line (SML): Rj = Rf + ?j ( Rm-Rf)
`?j’ is the market sensitivity of the security
= Covariance (j,m) / Variance (m)
= ? p (Rj- Rj ) ( Rm- Rm) / (? p (Rm-Rm)2 ) = ?j m ?j / ?m
? p =1
D. Cost of Capital Relationships (with taxation), asset and equity beta
(i) Kg = Ku + ( Ku-Kd) (l – T) (B/VS)
(ii) Vg = Vu + TB (with perpetual debt)
(iii) WACC=Ku(1-TL); L=B/Vg
(iv) ?eg = ?u + (?u -?d)(1-T)(B/Vs)
E. Dividend Valuation Models
P = ? ( Dt / (1+k)t )
(i) When the perpetual growth rate in dividends is `g,’ then
P = D1 / (k-g)
(ii) With constant dividends; P = D1/ k