Question 1

a. Calculate the NPV of the new project (ignoring tax).

We first have to calculate the beta of the firm’s risky assets. The beta of assets can be expressed as:

𝐸 𝐷
𝛽𝑎 = 𝛽𝑒 + 𝛽𝑑
𝐸+𝐷 𝐸+𝐷

We use excel to calculate βa to be equal to 0.95 and then calculate the beta of risky assets as per
calculations below. Since the risk of the project is identical to the risk of the “risky assets”, we can
use this beta to calculate the required rate of return of the project.

To calculate the discount rate we use the CAPM. According to the formula the required rate of
return can be calculated as follow:

𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑅𝑜𝑅 = 𝑅𝑖𝑠𝑘 − 𝐹𝑟𝑒𝑒 𝑟𝑎𝑡𝑒 + 𝐵𝑒𝑡𝑎 𝑜𝑓 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 × 𝑚𝑎𝑟𝑘𝑒𝑡 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚

4% + 1.14 × 7% = 11.98%

The project yields a perpetual annual return of 15% which means the perpetual annual cash flow is
the initial investment amount times the 15% return:

𝐶𝐹 = 15% × 1𝑚𝑖𝑙𝑙𝑖𝑜𝑛 = 150 000

We find the PV of this perpetual cash flow by dividing it by the discount rate calculated above

𝑃𝑉 = 150 000 ÷ 11.98% = 1 252 086.81

To calculate the NPV of the project we subtract the initial outlay of R1 000 000 from the PV to arrive
at the answer of R252 087

b. The CFO makes two arguments. Both are discussed separately below.

The argument that higher debt increases the firm’s profit per share and thus the value of the shares
According to Modigliani-Miller first proposition, in the absence of taxes, bankruptcy costs, agency
costs and market frictions and asymmetric information, the value of the firm is independent of its
capital structure. Therefore adding more debt will not increase the value per share (assuming the
investors cost of debt is the same as that of the firm). I therefore do not agree with the CFO’s
argument in a world without taxes since there are two offsetting factors to consider:
 Higher debt will increase the leverage of the firm which increases the riskiness of the firm
and the chances of the firm to default of its debt.
 At the same time higher debt will increase the profit per share.
 These two effects work in opposite direction so that the net effect is that there is no change
in the value of the shares.

However, in a world where there are taxes, increasing the debt will result in a higher value for the
shares due to the present value of the tax savings from debt. There is a tax shield from using debt
financing since interest is tax deductable so the source of additional value is due to the amount of
taxes saved by issuing debt instead of equity. Increasing debt will add value to a company until a
given threshold where the cost of bankruptcy might exceeds the value of the tax benefits. I
therefore agree with the CFO’s argument if taxes are taken into consideration.

The argument that due to the tax advantages of debt financing the WACC will be lower if you use
debt and therefore also the hurdle rate for investments
Debt financing does result in a lower WACC due to the tax shield of using debt (interest income is tax
deductable while dividends are not). The tax shield increase with debt so that a firm can raise its
value by substituting debt for equity and therefore WACC declines with leverage in a world with
taxes. The graph below summarise this, which is known as Modigliani-Millers second proposition
(MM II) with taxes.

Figure 1: MM II proposal
MM II without taxes says that as the leverage of a company increases, its return required on equity
increases in a linear fashion as shareholders demand a higher risk premium to compensate for the
increased riskiness of the firm due to the higher debt levels. The net effect of this is no change in
the WACC (the dotted yellow line in figure 1) and therefore the capital structure is irrelevant.
However, in a world with taxes, the tax savings from the interest tax deduction has an impact on the
WACC and therefore higher leverage leads to a lower WACC (the solid yellow line in figure 1).

I do not agree with the CFO’s statement that it will necessarily reduce the firm’s hurdle rate for
future investments because the hurdle rate for future projects will also depend on the risk profile of
future projects and how the future projects are financed.

c. Another capital structure hypothesis that supports the preference for debt financing is the
pecking order theory. The pecking order theory assumes managers will use internal funds
(retained profits) firsts, then debt and lastly only equity. Unlike other theories that attempt to
find an optimal capital structure, this approach simply states managers follow an established
pecking order which is the simplest and most efficient. The justification for the order of this
theory is as follow:
1. The issue cost of debt is lower than that of equity
2. The time and expenses involved with issuing debt is lower than that of equity and it can be
harder to persuade outside investors of the merits of the project than banks for example.
3. The existence of asymmetrical information available in the market. For example the
managers might have favourable inside information available about the project and would
not want to issue shares because they might think the shares and undervalued and not fully
reflecting the full value add of the project in the current share price. Using the same logic,
issuing shares might signal to the market that the shares are overvalued and thereby result
in investors selling shares in the company – therefore issuing shares is a last resort for the
company.
This theory implies that profitable firms will use less debt because they have more retained earnings
available and that companies will have a “lazy balance sheet” where they build up reserves to use
for future projects instead of having to go to the market.

Do I agree with the above mentioned arguments of the pecking order theory?
I do agree with the pecking order theory because there is asymmetry in the information available
between the market and managers. There will be a strong desire from management to keep inside
information proprietary if it operates in a competitive environment. Furthermore the pecking order
theory allows for a more dynamic approach to explaining the capital structure of a firm and takes
into consideration the specific time and specifics of the firm at that time (as appose to the theory
that there is one optimal capital structure the firm strives towards). The pecking order theory can
also explain the inverse relationship between profitability and debt ratios of firms. Lastly, there is
also empirical evidence in support of this theory.

Question 2
(The calculations for a, b and c was done in excel and copied over to this word document)
a. Assuming all the firm types issue equity and invest, we calculate the fraction of the firm’s
equity that has to be offered to the public to raise R3million in the equity offering
 We therefore conclude that 30% of the firm’s equity has to be offered to the public
b. Based on the answer in a, we consider which firms will find it profitable to undertake the
equity offering

Only firm E and W should invest and do the equity offering since in the case of firm type A,
the value to existing/original shareholders after the equity raise will be less than what it was
before the equity issuing.

c. If the managers decide whether to issue equity or not, only the managers that finds it
profitable will issue equity.

The issuing firms will have to give outside investors 33.3% of the equity to raise R3 million.
 d. The market values of the firms will be the average value of firm type E and W before the
investment (5.5) plus the NPV of the project for firm type E and W (0.5) (see table in c).
5.5+0.5=R6million. This is because it is assumed that existing shareholders will not be worst
off, but value will increase to them by the average positive value from the project (NPV of
the project). The difference between the 9 million after the investment and equity issuing
(calculated in c above) and the calculated 6 million represents the 33.3% dilution in the value
to shareholders.

e. We first calculate the amount of equity that needs to be issued to the public to raise R3m for
each firm type if it was known to the public.

Firm type Excellent (E): It will have to issue more shares at a price below the intrinsic value of the
firm since the value of the firm before the investment and after the investment is not known (30% vs
only 23% actually required if it was valued fairly). It is therefore expensive equity to issue for the
firm. After the investment the firm will be worth R13m, compare to R10m average. However, the
project will still be undertaken since the value to existing shareholders after the investment will be
more than before. This is because it is such a highly profitable investment (has a high positive NPV).
There is thus an incentive to under invest since the financing via equity is very costly.

Firm type Average (A): The NPV for the project is negative and the firm will not invest. Similarly to
the case of type E, it will issue equity below the value of the equity, making the equity issue extra
costly. After the issue the firm will actually be worth R12million and not the average of R10million.
There is no reason for the firm to invest in the project.

Firm Type Weak (W): Even though it has a negative NPV, it will still invest since it is able to issue
capital above the intrinsic value of the firm and thereby offsetting the negative NPV of the project.
The firm does invest but “overinvest” since it is undertaking negative NPV-projects.