Business Finance Assignment

Question 1: Cost of Capital

Reconsider Widget Ltd in Assignment 1. Assume your boss Diane Jones has asked you to re-estimate the company's cost of capital for capital budgeting purposes based on up-to-date information.

If the re-estimated cost of capital is different to that used previously, she would also like a brief qualitative assessment (no calculations necessary) of the impact of the difference on (a) the NPV of the project and (b) the value of the firm. Also discuss briefly the appropriateness of using the Widget cost of capital as a discount rate for the project.

Widget currently has 15,000 bonds outstanding paying a fixed coupon of 10% p.a. The bonds have a $1,000 par value and the coupon payments are semi-annual. The bonds are currently selling for 90% of par and have 10 years to maturity. The company has 8 million ordinary shares outstanding, currently selling for $5 per share, and 50,000 12% preference shares outstanding with a par value of $100, currently selling for $95 per share. The company also has a bank loan of $14 million with an interest rate of 9%. Widget has a tax rate of 30% and a beta of 1.8. It is expected that the company's current capital structure will remain the same. Treasury bonds are yielding 2.5% but some firms have bonds on issue yielding as much as 15%. The market risk premium is expected to be 7%.

Ensure you present your analysis in such a way that your boss will be able to easily follow what you have done and any assumptions you have made. Set out full workings in a clear and logical manner. Limit your answer to two A4 pages.

Marks for Question 1 will be awarded for correct choice and application of techniques in re-estimating cost of capital and appropriate qualitative assessment of impacts of re-estimated cost of capital (1.5 marks) and use as a discount rate.

Question 2: Share valuation

Your textbook provides share valuation examples related to an ASX listed company called JB Hi-Fi. In late 2016 JB Hi-Fi purchased a large private home appliance retailing company called The Good Guys with sales in the 2016 financial year of about $2 billion. Your task is to value JB Hi-Fi's shares and discuss the results. Collect all required data from Morningstar DatAnalysis.

Answer each of the following:

(a) Assuming the same equity cost of capital as given on page 210 of the text, but using the total dividends per share paid by JB Hi-Fi in the 12 months to 31st December 2016, value the shares assuming constant dividend growth of (i) 5.69% and (ii) 7%.

(b) Pages 298-299 of the text show an example of valuing JB Hi-Fi shares using free cash flow. You are required to update this valuation.

Use calendar years for your updated valuation to keep things simple. Start your new valuation with an assumption of 2016 calendar year sales of $6 billion ($6,000 million) for the combined company and estimate the future calendar year free cash flows from 2017. Assume calendar year sales growth of 4% in 2017, 4% in 2018 and 3% thereafter. These are similar growth assumptions as the example in your text. Make the same assumptions as the text example about the EBIT margin, net working capital changes, equivalence of capital expenditures and depreciation expenses, tax rate and cost of capital. Update the cash, debt and shares outstanding figures to their 31st December 2016 interim balance sheet values.

(c) Compare your valuations in (a) and (b) to each other and to JB Hi-Fi's actual closing share price on 31 December 2016. Explain the differences and discuss whether you would recommend buying the shares.

Question 3: Capital Structure

Reconsider the information you have on Widget Ltd from Assignment 1

and Question 1 in the current assignment. Assume your boss Diane Jones is concerned about the firm's heavy reliance on debt and has asked you to develop an argument based on trade-off theory for the need to shift the firm's capital structure more towards equity. Further information on Widget that may help you in this task is:

Widget has traditionally had variable earnings and operating cash flows, although it has made a taxable profit each year.

The firm's earnings are almost entirely related to software development. This highly competitive industry is subject to rapid technological change.

90% of the firm's book value assets are intangible.

Ensure you refer to the company's characteristics and context to support your argument.

Marks for this question will be allocated for demonstrated ability to explain trade-off theory and apply it to the capital structure decision in a particular company context. Limit your answer to about 1 page or 500 words.