Question

3. Omaera an unlevered firm generates average earnings before interest and tax of sh.20m p.a. The market value of the company as at 31 October 2017, the financial year end was 120m. The management of the company is considering the use of debt finance and have provided the following additional information: (0) Estimated present value of any future financial distress cost is Shs. 80m. (ii) The probability of financial distress would rise with leverage according to the following schedule. Value of debt (sh. M) Probability of financial distress 0.00 0.0125 0.0250 0.0625 0.1250

continued..

Answer 1

1. Higher the borrowing, better it is for the company. Hence Optimum level of debt is sh 200m as it is the highest amount given in the question. As debt is cheaper it is better to go for debt as WACC will mostly come down.

Currently the Ke (Cost of equity/unlevered firm) is 20/120= 16.67%

By engaging more debt Cost of capital will come down as tax benefit is available for interest cost.

Value of Levered firm as per MM approach= Value of unlevered firm+ Debt*tax rate

% of debt over Total value is 200/(200+120)=62.5%

62.5% debt and 37.5% equity

Value of levered firm in this case is 120+200*0.3=120+60=sh 180m and it is the highest

2. In the second scenario we have to see what's the value of firm in each case as distress cost is associated with different levels of borrowing

a) when borrowing is 25m

financial distress cost= 80*0=0

value of levered firm is 120+25*0.3=120+7.5=sh 127.5m

b) when borrowing is 50m

financial distress cost= 80*0.0125=10

financial distress cost has to be reduced

value of levered firm is 120-10+(50*0.3)=120-10+15=sh 125m

c) when borrowing is 75m

financial distress cost is 80*0.025=2

value of levered firm is 120-2+(75*0.3)=120-2+22.5=sh 140.5m

d) when borrowing is 100m

financial distress cost is 80*0.0625=5

value of levered firm is 120-5+(100*0.3)=120-5+30=sh 145m

e) when borrowing is 125m

financial distress cost is 80*0.125=10

value of levered firm is 120-10+(125*0.3)=120-10+37.5=sh 147.5m

f) when borrowing is 150m

financial distress cost is 80*0.3125=25

value of levered firm is 120-25+(150*0.3)=120-25+45=sh 140m

g) when borrowing is 200m

financial distress cost is 80*0.75=60

value of levered firm is 120-60+(200*0.3)=120-60+60=sh 120m

Result: The highest among the seven has to be selected . The value of company is highest when borrowing is made for sh 125m as the value of the levered firm stands at sh147.5m

Hence sh 125m should be borrowed in second scenario