BUSF_A01.qxd

Appendix 4 • Suggested answers to selected problem questions

The share price would be identical (£2.40) because the lower risk attaching to the returns

in the all-equity business would be exactly compensated by lower returns as a result of the

absence of the cheap loan finance.

11.3 Particulate plc

(a)According to MM the value of a geared business (VG) is equal to the value of the equi-

valent all-equity-financed (VU) one plus the value of the so-called tax shield provided by

the tax relief on loan interest (TBG), that is:

VG=VU+TBG

Thus, for Particulate plc:

VG=£35m+(£8m×0.30) =£37.4m

This is made up of £8m loan finance and £29.4m equity.

(b)Equity earnings are expected to be constant as follows:

£m

Annual earnings after tax (£35m ×20%) 7.00

Add: Tax (£7.00m ×30/70) 3.00

Annual earnings before tax 10.00

Less: Interest (£8m ×10%) 0.80

9.20

Less: Tax @ 30% 2.76

Available for shareholders £6.44

The business’s cost of equity is:

kE=6.44/29.4 ×100% =21.9%

(c)The weighted average cost of capital (WACC)

==18.7%

Thus WACC has decreased from 20 per cent to 18.7 per cent as a result of introducing the

debt finance. At the same time the cost of equity has increased from 20 per cent to 21.9 per

cent as a result of the increased risk that shareholders will have to bear.

11.5 Ali plc

Return on equity earned by the business =[12.80/(10 × 4 ×1.60)] ×100% =20%.

Assuming that the same level of return is earned on the additional finance, after the

rights issue, Lee’s investment in the business would be:

Original investment (10,000 ×£1.60) £16,000

Rights issue [(10,000/4) ×£1.20] £3,000

£19,000

After the expansion, by either means, the pre-interest profit would be 20% ×[(10m × 4

×£1.60) +(2.5m × 4 ×1.20)] =£15.2m. Therefore the dividend per share is 15.2/50 =£0.304.

(21.9 ×29.4) +[10 ×(1 −0.30) ×8]

29.4 + 8

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