Lindsay White, CFA, is an analyst with a firm in London, England. She is responsible for covering
Question:
Lindsay White, CFA, is an analyst with a firm in London, England. She is responsible for covering five companies in the Consumer Staples industry. White believes the domestic and global economies will grow slightly below average over the next two years, but she is also concerned about the possibility of a mild recession taking hold. She has been asked to review the companies that she covers and has collected information about them, presented in Exhibit C. White has estimated that earnings before interest and taxes (EBIT) will remain constant for all five companies for the foreseeable future. Currency is in terms of the British pound (d). The marginal corporate tax rate is 30 percent for all five companies.
EXHIBIT C: Selected Company Financial Data
Aquarius | Bema | Garth | Holte | Vega | |
EBIT (£) | 600,000 | 600,000 | 400,000 | 400,000 | 400,000 |
Debt-to-equity ratio (market value) | 0.60 | 0.00 | 0.00 | 0.71 | 0.62 |
Debt (market value) (£) | 2,000,000 | 0 | 0 | 2,000,000 | 2,000,000 |
S&P debt rating | A+ | n.a. | n.a. | A- | A |
Weighted average cost of capital | -- | 10% | 10% | -- | -- |
Based on conversations with management of the five companies, as well as on her own independent research and analysis, White notes the following:
Aquarius:
Has lower bonding costs than does Bema.
Has a higher percentage of tangible assets to total assets than does Bema.
Has a higher degree of operating leverage than does Bema.
Garth:
Invests significantly less in Research and Development than does Holte.
Has a more highly developed corporate governance system than does Holte.
Has more business risk than does Holte.
In addition, White has reached various conclusions regarding announcements by Bema,
Garth, and Vega:
Announcement: Bema has announced that it will issue debt and use the proceeds to repurchase shares. As a result of this debt-financed share repurchase program, Bema indicates that its debt/equity ratio will increase to 0.6 and its before-tax cost of debt will be 6 percent.
Conclusion: As result of the announced program, Bema’s total market value should decrease relative to Aquarius’s.
Announcement: Garth has announced that it plans to abandon the prior policy of all equity financing by the issuance of d1 million in debt in order to buy back an equivalent amount of equity. Garth’s before-tax cost of debt is 6 percent.
Conclusion: This change in capital structure is reasonable, but Garth should take care subsequently to maintain a lower D/E ratio than Holte.
Announcement: Vega has announced that it intends to raise capital next year, but is unsure of the appropriate method of raising capital.
Conclusion: White has concluded that Vega should apply the pecking order theory to determine the appropriate method of raising capital.
Based on the Modigliani and Miller (MM) propositions with corporate taxes, Aquarius’s WACC is closest to:
a. 3.38%.
b. 7.87%.
c. 11.25%.
Based on MM propositions with corporate taxes, what is Bema’s weighted average cost of capital after the completion of their announced debt-financed share repurchase program?
a. 6.52%.
b. 7.83%.
c. 8.88%.
Based on Exhibit C and White’s notes, which of the following is least consistent with White’s conclusion regarding Bema’s announcement?
a. Bema’s bonding costs will be higher than Aquarius’s.
b. Bema will have a lower degree of operating leverage than does Aquarius.
c. Bema will have a lower percentage of tangible assets to total assets than does Aquarius.
Based on the MM propositions with corporate taxes, Garth’s cost of equity after the debt issuance is closest to:
a. 10.00%.
b. 10.85%.
c. 11.33%.
Based on Exhibit C and White’s notes, which of the following is most consistent with White’s conclusion regarding Garth’s announcement?
a. Garth has more business risk than does Holte.
b. Garth invests significantly less in Research and Development than does Holte.
c. Garth has a more highly developed corporate governance system than does Holte.
Expert Answer:
The detailed answer for the above question is provided below SOLUTION Here are the answers 1 Based on the Modigliani and Miller MM propositions with c... View the full answer
