AZIRIDINATION
3.1. INTRODUCTION
3.1.3. INTRAMOLECULAR AZIRIDINATION
3.1.3.2. MECHANISTICAL IMPLICATIONS IN THE COPPER- AND RHODIUM- RHODIUM-CATALYSED AZIRIDINATION REACTION MEDIATED BY
Text references. Chapter 7a for theories of capital structure, for credit spreads and the effects on cost of debt.
Top tips. The wording in part (a) suggests that you need to calculate a coupon rate – in fact the only calculation required is that of the yield of the four year government bond. You have to recognise the effects of incorrect estimations of the credit spread and explain these effects.
There is quite a bit of work involved in part (b) for 8 marks, compared with what is required for the same number of marks in part (c). The question does not give you the current value of debt therefore you will have to calculate that first before you can calculate the effect on this value. One of the more complex calculations (not the calculation itself but recognising what you have to do) is working out the percentage effect on current value.
Remember to answer the actual requirement in part (b) – it is easy to forget to determine the increase in the effective cost of debt capital.
Part (c) is not particularly difficult but is complicated by the confusing statement about the company's stated financial objectives, when in fact there are no objectives stated in the question. As mentioned above, there is not much to be done for 8 marks but make sure you relate your answer to the specific company in the scenario.
Easy marks. There are some relatively easy marks to be gained in part (c) regarding the advantages and
disadvantages of debt. Part (d) is fairly straightforward, but ensure that you only discuss company specific factors.
Examiner's comments. Candidates with an understanding of the principles behind debt and the debt market gained high marks.
In part (a) very few candidates appreciated that the investors' required return would be the coupon rate on a new issue to ensure that it is fully subscribed at par.
In part (b) very few candidates managed to navigate a relatively simple set of calculations. The current gearing ratio and the market capitalisation of equity leads directly to an estimate of the current market value of debt and, given that the market yield is the current coupon, its par value. The alteration in the company's credit rating leads to a revised market value for this equity and at this point candidates had sufficient information to estimate the average cost of debt capital.
In part (c) few candidates appeared to have an understanding of ways in which large amounts of debt can be raised through a bond issue, leasing, syndicated borrowing or single source finance.
Marking scheme
Marks
(a) Advice on the appropriate coupon rate 4
(b) Estimate of current value of debt 2
Estimate of market value of debt following new issue 3
Calculation of revised cost of debt capital 3
8 (c) Relative advantages and disadvantages
Asset specificity and matching 2
Agency effects 2
Static trade-off arguments 2
Pecking order 2
8
(d) One mark per explained factor Max 5
25
(a) The appropriate coupon rate for the new debt issue should be the same as the yield for the four year debt, which is calculated as follows:
Yield for 4 year debt = risk free rate + credit spread
= 5.1% + 0.9% (0.9% is the 90 base point spread) = 6%
The investment bankers have suggested that at a spread of 90 base points will guarantee that the offer will be taken up by the institutional investors. If the spread was set too high, the debt would be issued at a premium; if it was too low then it would have to be issued at a discount as there would not be a full take-up.
(b) Impact of new issue on the company's cost of debt and market valuation
When new debt is issued this will increase the risk of the company, resulting in a reduction in the company's credit rate and/or an increase in the company's cost of debt.
Current amount of debt in issue
Using the company's current gearing ratio of 25%, we can calculate the current amount of debt in issue:
Gearing = MV of debt
Thus the current market value of debt in issue is $0.4 billion. This is actually the par value as well, given that the coupon rate of 4% and the market yield (3.5% + 50 basis points) are the same.
Effect of new debt on market value of current debt
As mentioned in part (a) above, the yield on the new debt will be 6% (5.1% + 90 basis points). If we assume that this new debt is issued at par at 6%, the market value of existing debt will be reduced by the reduction in credit rating and the increase in yield to 4.4% (that is, original yield of 4% + [90 – 50] basis points).
This means that the new market value of current debt will be 98.9% (100 – 1.1%) of the current market value.
New market value = 98.9% of $400 million = $395.6 million
If the new debt of $400 million is – as expected – taken up at the par value then total market value of debt in issue will be:
$395.6 million + 400 million = $795.6 million Effect of new debt on cost of debt capital
Using the yields calculated above (6% for new debt; 4.4% for existing debt), the revised cost of debt capital can be calculated on a weighted average basis, adjusted for the effect of tax:
Cost of debt = 400 million 395.6 million
× 6% + × 4.4% × (1- 0.30)
The effect of the new debt issue on cost of debt is to increase it by 84 basis points (3.64% – 2.8%).
What should be borne in mind is that part of this increase will be due to the longer term to maturity (4 years rather than 3 years).
(c) Advantages and disadvantages of debt as a method of financing Relative lower cost of debt compared with equity
One of the advantages of debt is that, due to the tax shield on interest payments, it is a relatively cheaper form of financing than equity (whose dividends are paid out of earnings after tax). As such we would expect the higher level of gearing to lead to a fall in the weighted average cost of capital.
Appropriate to the industry and specific assets
The company is in the airline industry where debt tends to be a more appropriate method of finance, given that many of the assets can be sold when they are being replaced. In this case, the company is using debt to acquire new aircraft where a second-hand market does exist.
Signalling and agency effects
Companies tend to prefer debt to equity as a method of financing. This is mainly due to the tax shield offered by interest payments on debt. If the company increases its level of debt financing, the market could interpret this as meaning that management believe the company is undervalued. There is a significant agency effect arising from the legal obligation to make interest payments. Managers are less inclined to divert money towards financing their own incentives and perks if they know they have such legal obligations to meet.
Alteration of capital structure
One of the problems with debt financing is that it could be viewed as increasing the risk of the company to equity holders, given that there is a legal obligation to pay interest before dividends can be paid. As a result, investors may require a higher rate of return before they will be tempted to invest money in the company.
(d) Management evaluation
The rating agencies will look at the overall quality of management and succession planning, as well as performance from mergers and acquisitions and financial performance based on financial statements.
Financial gearing
The level of financial gearing will be considered; typically, companies with a low level of gearing will have a higher credit rating.
Position in the airline industry
The relative position of the company within the airline industry in terms of operating efficiency will be taken into account.
Accounting quality
There will be a general consideration of the accounting policies which could be used to manipulate profits (such as goodwill and depreciation) and whether there have been any qualifications to the audit report.
Earnings protection
Existing and projected measures such as return on capital and profit margins will be considered. Sources of future earnings growth will also be taken into account.
Cash flow adequacy
The relationship between cash flow and gearing and the ability to finance the cash needs of the business are important factors to be considered.
Financial flexibility
Financing needs will be evaluated, including alternatives in situations of financial stress. Agencies will also consider banking relationships and any restrictive debt covenants.
31 Fubuki
Text references. NPV is covered in Chapter 5 and APV in Chapter 7a.
Top tips. It is not immediately obvious that APV calculations are required – at this level of examination you are expected to recognise the potential impact of the method of financing. You will still gain marks for calculating the base case NPV but will fail to gain any of the marks available for the APV aspect of part (a).
Be careful which discount rate you use to calculate NPV – you should be making use of the information given on the company in a similar line of business to the new venture. When calculating the tax shield and subsidy effects for APV, make sure you state which rate you use as there are two rates that are feasible.
Part (b) demonstrates the importance of assumptions as you are required to explain any assumptions that you have made. Don't just state the assumptions you think require more explanation – make sure you list all the
assumptions made, regardless of how obvious you think they might be.
Easy marks. There are easy marks to be gained in part (a) when calculating base case NPV.
Examiner's comments. The computational element of (a) was done well, but common errors occurred when calculating the working capital requirement (where many answers got the timing wrong) and when calculating the tax shield and value of the subsidy for the APV. Many candidates derived the cost of equity using geared and ungeared betas, whereas using the MM formula would have been less time consuming.
Answers that gained high marks in part (b) gave a detailed discussion of the method used and explanation of the assumptions made. Weaker answers tried to answer this part in brief note form and these did not gain many marks. Many answers did not discuss the link between APV and MM.
Marking scheme
Marks (a) Sales revenue, direct costs and additional fixed costs 4
Incremental working capital 1
Taxation 2
Estimation of ke (ungeared) 2
Net cash flows, present value and base case NPV 2
Issue costs 1
Calculation of tax shield impact 2
Calculation of subsidy impact 1
Adjusted present value and conclusion 2
17
(b) Discussion of using APV 2 – 3
Assumption about Haizum as proxy and MM proposition 2 3 – 4
Other assumptions 2 – 3
Max 8 25
(a) Net present value
0 1 2 3 4
$m $m $m $m $m
Sales (W1) 3.250 4.687 6.757 7.308
Direct costs (W2) (1.560) (2.359) (3.567) (4.045)
Specific fixed costs (W2) (1.000) (1.050) (1.102) (1.157)
Taxable cash flows 0.690 1.278 2.088 2.106
Tax (25%) (0.173) (0.320) (0.522) (0.527)
Capital allowances (W3) 0.163 0.163 0.163 0.163
Capital expenditure (14.0)
Sale of project 16.000
Working capital (W4) (0.488) (0.215) (0.311) (0.082) 1.096
Net cash flows (14.488) 0.465 0.810 1.647 18.838
Discount factor (W5) 1.000 0.909 0.826 0.751 0.683
DCF (14.488) 0.423 0.669 1.237 12.866
Base case NPV = $0.707m (positive but marginal) Workings
1 Sales
1 2 3 4
Sales units 1,300 1,820 2,548 2,675
Selling price (3% increase pa) $2,500 $2,575 $2,652 $2,732
Sales revenue $3.250m $4.687m $6.757m $7.308m
2 Costs
Tutorial note. Remember that only specific fixed costs should be included in the NPV calculation – allocated fixed costs are not relevant.
1 2 3 4
Sales units 1,300 1,820 2,548 2,675
Direct costs/unit (8% increase pa) $1,200 $1,296 $1,400 $1,512
Total direct costs $1.560m $2.359m $3.567m $4.045m
Specific fixed costs (5% increase pa) $1m $1.05m $1.102m $1.157m 3 Capital allowances
Capital allowances (tax allowable depreciation) are available on plant and machinery at a rate of 25%
(straight line basis).
Annual capital allowance will be 25% of $3 – 0.4 m = $0.65m Tax benefit = $0.65m × 25% = $0.163m pa
Tutorial note. You could also have assumed that capital allowances were $0.75m in the first three years and $0.35m in the final year. You would gain full credit for this.
4 Working capital
Tutorial note. It is only the extra working capital required each year that should be included in the NPV calculation. Don't be tempted to include the full 15% of each year's sales revenue as the annual working capital requirement. You should only include the difference between this year's working capital requirement and that required for next year.
Working capital requirement
1 2 3 4
Total sales revenue $3.250m $4.687m $6.757m $7.308m
Total working capital required for the year (15% of sales revenue)
$0.488m $0.703m $1.014m $1.096m
Incremental working capital $0.488m $0.215m $0.311m $0.082m
Year in which accounted for 0 1 2 3
5 Discount factor
We assume that the ungeared cost of equity will be used to discount the project as this represents the business risk associated with this new venture.
ke = ie ie d d
e
k +(1- T)(k -k )V V
Vd = $40m × 0.9488 = $37.952m (where 0.9488 represents the fraction of the par value at which the debt is trading)
Tutorial note. You could also have estimated the discount rate by calculating the asset beta and then using that to calculate the cost of equity.
Financing side effects
$m
Issue costs (4/96 × $14.488m) (0.604)
Tax shield on debt (W6) 0.764
Subsidy benefit ($14.488m × 80% × 0.02 × 75% × 3.588) 0.624
Net benefits of financing side effects 0.784
Add base case NPV 0.707
Adjusted NPV 1.491
When the side effects of financing are taken into consideration the project looks more attractive. The NPV is less marginal and the project is likely to be accepted.
Tutorial note. You might have included the issue costs in the funds borrowed. This would still give you the full credit of marks.
6 Tax shield
Fubuki Co can borrow at 300 basis points above the five-year government debt yield rate of 4.5% – that is, 7.5%.
The government has offered Fubuki a subsidised loan of up to 80% of the funds required ($14.488m) at a rate of 200 basis points below Fubuki's borrowing rate of 7.5% (that is, 5.5%).
Annual tax relief
$m
Subsidised loan ($14.488m × 80% × 5.5% × 25%) 0.159
Remainder of loan ($14.488m × 20% × 7.5% × 25%) 0.054
Total 0.213
Discounted at 4.5% debt yield rate for four years – annuity factor of 3.588
Present value of tax shield 0.764
Tutorial note. Instead of using 4.5% to discount the tax relief, you could have used 7.5% as this is Fubuki's normal borrowing rate and reflects its normal risk.