(Both parts are compulsory) I) Examine the impact of a) issuing £1 billion in ne

Question

(Both parts are compulsory)

I)

Examine the impact of a) issuing £1 billion in new debt (adding a modest level of debt) and b) issuing £5 billion in new debt (i.e. adding a higher level of debt). In both the cases, you plan to use the proceeds to repurchase stock.

(Notes: How to do this part-

Assume a tax rate of 40%

Begin by analyzing the scenario with £1 billion in new debt.

Assuming the company plans to keep this new debt outstanding forever, determine the present value of the tax shield of the new debt.

Find out new market value of equity. New market value of equity = existing market value + tax shield amount

Find out new market value of equity after repurchase v.

Find out the new share price

New number of shares outstanding = no of shares outstanding (given) less number of shares repurchased

Now find out Debt to Equity ratio based on a) book values and b) market values

Repeat for £5 billion new debt issuance.)

ii) (capital structure theories)

Read and review journal articles related to Trade off, Asymmetric of the information hypothesis, Pecking order theory, Signaling theory, Agency cost theory, and Market timing theory.

You are a new recruit in the finance division of LargeCompany Plc. Your finance director has asked you to review the company's capital structure when the amount of debt is changed. She has provided you following information from last year annual report Short Term Debt/Current Portion of Long Term Debt Long Term Debt Total Equit Shares Outstandin in '000 £1,700,000 £9,700,000 £18,000,000 1,700,000 Further, you collected following market information from the New Financial Times. Stock Price (per share Current Yield to Mat E 27 0.90% on outstanding Bond Cost of unlevered equity is 10 %

Explanation / Answer

(in '000) Particulars Present Issue 1000000 debt Issue 5000000 debt Total Debts 11400000 12400000 16400000 YTM 0.90% 0.90% 0.90% Interest 102600 111600 147600 Tax rate 40% 40% 40% Tax sheild 41040 44640 59040 Net Interest expense 61560 66960 88560 Total Equity 18000000 17607843 16039216 Shares o/s 1700000 1662963 1514815 10.59 10.59 10.59 M.P. of share 27 No of shares repurchase 37037 185185 New market value 17652483 16098256

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