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Cima F3 Exam Question No 14

Question No 14:

FF is a company that specialises in the manufacture, supply and installation of fixtures and fittings for offices. It uses F$ as its currency. FF is currently evaluating a project to build a new distribution and sales centre.

The company is currently wholly equity funded and has 30 million shares in issue. The share price is F$11 per share before announcing the proposed project and the ungeared cost of equity is 9%. FF pays corporate income tax at 25%.

The proposed project requires an initial capital investment of F$80 million. The present value of future cash flows following this initial investment is estimated to be of the order of F$110 million, based on a discount rate of 9%. The F$30 million forecast increase in entity value is expected to be fully reflected in the share price immediately the project is announced.

There has been some discussion amongst the directors of FF about how the F$80 million capital investment should be funded. Any new equity would be raised through a rights issue and any borrowings would be at a pre-tax cost of 7%. Both would be required indefinitely. Three alternative financing structures are being considered as follows:

• A: F$80 million equity funding.
• B: F$80 million borrowings.
• C: F$48 million equity plus F$32 million borrowings. 

Required:
(a) Calculate the following, based on Modigliani and Miller’s (MM’s) capital theory with tax and assuming the project goes ahead:
(i) The total value of FF (before deducting debt) on a discounted cash flow basis for each of the financing structures A, B and C.

(ii) FF’s WACC for each of the financing structures A, B and C.

Note that MM formulae are provided on pages 23 and 24.
.
(b) Explain your results in (a) above with reference to MM’s capital theory with tax, illustrating your answer by drawing graphs of your results in (a) above. Use the graph paper provided.

(c) Advise, with reasons, which financing structure FF should adopt.

Answer:

 Level of gearing
Under MM (with tax), increasing gearing increases the value of the company due to the tax relief available on debt and nothing else. Given that the value of the debt is determinable then the increase in value associated with the tax shield on the debt will flow to the equity providers and hence increase shareholder wealth.

Also, by introducing debt finance, the overall (weighted average) cost of capital falls. This is because the increasing cost of equity resulting from the additional debt being taken on is more than off-set by the impact of the tax shield on that debt.


Requirement (c)
I would advise that FF proceed with funding structure B as it gives the greatest value of shareholder wealth value without creating significant danger of financial distress due to the low gearing level created.

The value of FF and hence also shareholder wealth (since the value of debt remains constant) is increased largely due to the tax benefit in perpetuity that arises from the use of debt financing.
MM’s theory based on a number of assumptions which do not necessarily hold in practice. These assumptions include:

• MM ignores the impact of financial distress at very high levels of gearing which will push up the cost of equity (and usually the cost of debt) to such an extent that the WACC will increase.
• MM is also based on unrealistic assumptions about perfect capital markets and perfect information.
However, these considerations are not important here as the level of debt being considered is quite small, being just approximately 20% of the value of the company.