QUESTION 3
A new finance intern at Jaclyn Handbags Inc has advised the
board of directors to increase the company’s capital gearing to
60%, to reduce its cost of capital and increase its market value.
The managing director of Jaclyn Handbags is not convinced by the
logic of the proposal, or the accuracy of the calculations, but is
unable to explain the reasons for his reservations.
A summary of the proposal and its implications is shown
below.
Proposal to increase the capital gearing of Jaclyn
Handbags Inc.
The company's current weighted average cost of capital is
estimated to be 14.52%. If the proportion of debt is increased to
60% of total capital, by the repurchase of ordinary shares at their
current market value and issuing long-term debt, the cost of
capital may be reduced to 13.79%. A reduced cost of capital means
that the value of the company will increase which will be welcomed
by our shareholders. Calculations supporting the above proposal are
shown below:
- Plz Plz Help Question 3 A New Finance Intern At Jaclyn Handbags Inc Has Advised The Board Of Directors To Increase The C 1 (38.82 KiB) Viewed 51 times
i. The current price of Jaclyn Handbags’ ordinary shares is 450
cents.
ii. The market price per $100 nominal value of 10.5% loan stock
is $113.
iii. The market return is 14% and the risk free rate 7.0%.
iv. Jaclyn Handbags’ equity beta is 1.3.
v. Jaclyn Handbags currently pays $10 million in dividends.
vi. Most recently summarised statement of financial position is
as follows:
Jaclyn Handbags Inc.
$m
Non-current assets (net)
500)
Current assets
700)
Less current liabilities
(300)
900)
Issued ordinary shares (50 cents par)
500)
Reserves
150)
Liabilities falling due after one year:
10.5% loan stock redeemable in 5 years ($100 par value)
250)
900)
vii. The corporate tax rate is 30%.
viii. The company currently generates a free cash flow of $100
million (after tax) per year, which is expected to increase by
approximately 5% per year.
Required:
a) Create revised estimates of the company's
current cost of capital and the current value which is correct for
any mistakes. A brief explanation of the reasons for any revisions
should be included.
b) Assuming the cost of equity and cost of debt
do not alter, estimate the effect of the share repurchase on the
company’s cost of capital and value. Summarise the potential
disadvantages of increasing the gearing ratios.
Existing cost of capital Cost of equity using capital asset pricing model: 7% + (14% - 7%) 1.3 = 16.1% Cost of debt: 10.5% Weighted average cost of capital: 16.1% x $650m + 10.5% < $250m = 14.52% $900m $900m Estimated new cost of capital: 16.1% * $360m + 10.5% * $540m = 13.79% $900m $900m Impact on the value of the company: Current value $100m = $689 million 0.1452 Expected new value $100m = £725 million 0.1386