a) Beta of assets = Beta of debt + Beta of equity
Beta of assets = 1.5 + 0.1
Beta of assets = 1.6
b) Beta of assets of firm = Beta Jet Engines + Beta Locomotive + Beta Construction
1.6 = 1.1 + Beta Locomotive + 1.2
Beta Locomotive = 2.3 – 1.6
Beta Locomotive = 0.7
a) If they consisted of separate projects, the ones with the highest internal rate of return would be chosen. However, if they are mutually exclusive projects other factors ought to be considered (Brockington B. R. 1993, p 114-115). For instance, the initial capital expenditure should be considered in these proposed projects.
In view of the capital rationing issue:
(3,000,000 x 0.121)/5,000,000 = 0.0726
(2,000,000 x 0.09)/3,000,000 = 0.06
(6,000,000 x 0.17)/8,000,000 = 0.1275
(5,000,000 x 0.14)/6,000,000 = 0.1167
(0.16 x 12)/18 = 0.1067
(0.17 x 12)/18 = 0.1133
(0.14 x 12)/18 = 0.0933
*Required rate of return is the same as overall expected return leading same figures.
Entertainment required return = 6% + 2(12% – 6%)
Entertainment required return = 18%.
c) The difference in the cost of capital led to different figures for the entertainment section. Project E2 is the most viable one which differs from the answer of part (a) of Project E1.
If the overall cost of capital is adopted we shall prefer Project E1. In such a stance the cash outflow would be lower by $2 million, leading to additional cash to be invested in order feasible projects. Thus in the long-term more cash will be available or the debt commitments will be lower if it will be financed by debt. Leading to better stability for the firm. If equity was chosen as the medium of finance the share capital value would be lower, thus increasing the earnings per share of the stock holders.
ERj = Rf + þj(ERm – Rf)
Where: ERj = Required return on the shares of the company
Rf = risk-free rate of return
ERm = expected return on the market
Þj = slope of the regression line
ERj = 3.5% + (0.7 x 0.5)(6% – 3.5%)
ERj = 3.5% + 0.35(2.5%)
ERj = 4.375%
a) The efficient market hypothesis is based on the premise that the current market prices fully reflect available information in the market. Three levels of efficiency are set under this theorem, whose efficiency relies upon the extent and speed with which the capital market mirrors new information on the stock price. Under this proposition the shares of companies listed in such markets are never over- or under-valued and it is practically impossible to outperform the market consistently. Since the situation provided sheds light on one investment, there is the possibility that the market was outbid by luck. However if this is achieved recurrently, in such instances the market efficiency is violated (Pike R. et al 1999, p 44).
b) Under the efficient market hypothesis it is stated that it is useless attempting to estimate potential share price movements from examination of past events. This questions the reliability of such technical analysis. Due to such efficient speed of information in the market all the key players in an efficient market will know all relevant data. Thus if financial analysts forecast a profitable investment, investors will commence investing in it leading to a reduction return reaching break-even (Pike R. et al 1999, p 45).
The capital structure decision basically rests between equity and debt financing. There are certain inherent characteristics in share capital and loan finance that ought to be considered thoroughly before setting a capital structure because they pose certain financial benefits or burdens on the company.
Debt finance has certain tax savings implications over equity finance. Interest on debt is deducted before taxable profits, while dividends given to equity investors are diminished from the profit after the taxation charge (RH Smith School of Business). For example Red Ltd and Blue Ltd are two firms operating in the same industry. During the year ended 2006, both companies incurred an operating profit before interest and taxation of £100,000. The capital structure of Red Ltd. is made up of 200,000 ordinary shares of a nominal value of £1 each, while Blue Ltd. capital comprises £100,000 10% debentures and 100,000 £1 ordinary shares. Each company has a dividend policy of 10% from the available profits. The corporation tax is presumed at 35% of taxable profits. The taxation of each firm would amount as follows:
Profit and Loss Appropriation Account for year ended 31st December 2006
Debenture Interest (£100,000 x 10%)
Profit on ordinary activities before taxation
Profit on ordinary activities after taxation
Ordinary dividends proposed
As can be seen the retained profits of Blue Ltd. are higher due to the tax saving arising from debt.
In the capital structure decision the financial risk of the company should be considered carefully. A high-geared company normally has a lower stability than low-geared firms. In practice, a company is usually declared bankrupt when the financial position of the enterprise is so weak that it cannot meet interest and loan commitments. Thus the higher the amount of debt the greater this risk because the interest and loan obligations are more material (RH Smith School of Business).
The costs arising from financial distress are another issue on capital structure. Every organization facing either a voluntary or creditors winding up entail dissolution costs, which will ultimately be taken out of the funds available for shareholders. The higher the debt finance the more elaborate the liquidation requiring complex ranking decisions, especially if specific or general securities are in place. Therefore the accountancy and legal costs will be higher in such situations (RH Smith School of Business).
The last but not least important factor in capital structure decisions is financial slack. Financial slack comprises the amount of funds available to invest without the need of external markets. Such feature is influenced by the capital configuration of the firm. We shall illustrate its effect with the aid of an example. Let us consider two firms operating in the same industry, Equity Ltd and Debt Ltd. The source of finance adopted by Equity Ltd consisted of share capital, in which he sold 90% shareholding to a friend, while Debt Ltd. owner kept all the share capital and attained a 90% debt finance to run the firm’s operations. In a particular period both firms achieved good profitability during the winter season. In summer they forecast to attain an overall operating profit of £25,000. Both owners wish to take a break and forego this anticipated profit. The entrepreneur of Equity Ltd notices that he will receive only 10% of the profit and therefore decides to take the holiday. However Debt Ltd realizes that all the profits after interest and tax will be his and thus prefers to work. We can thus deduce that debt financing induces higher efficiency and less wastage (RH Smith School of Business).
a) (1 + rus) = (1 + ruk)St + 1
Where: rus = risk-free return in U.S.
ruk = risk-free return in U.K.
St = the current spot rate.
St + 1 = spot rate in 1 one year.
Year 1: (1 + 7%) = (1 + 5%) St + 1
1.07 x 0.56 = 1.05 (St + 1)
0.5992 = 1.05(St + 1)
(St + 1) = 0.5992
(St + 1) = 0.57
Year 2: (1 + 7%) = (1 + 5%) St + 1
1.07 x 0.57 = 1.05(St + 1)
(St + 1) = 0.58
Year 3: (1 + 7%) = (1 + 5%) St + 1
1.07 x 0.58 = 1.05(St + 1)
(St + 1) = 0.59
Discount factor at 9.25%
Present Value in U.S. $
Net Present Value: ($4,028)
Brockington B. R (1993). Financial Management. Sixth Edition. London: DP Publications.
Pike R.; Neale B. (1999). Corporate Finance and Investment. Third Edition. London: Prentice Hall.
RH Smith School of Business. Capital Structure (on line). Available from: http://www.rhsmith.umd.edu/finance/gphillips/courses/Bmgt640/Capstr.pdf (Accessed 24th April 2007).
 Corporation in which debt is in a higher proportion than equity in the capital structure.
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