Location via proxy:   [ UP ]  
[Report a bug]   [Manage cookies]                
Scribd Logo
Upload

Welcome to Scribd!

  • 51 views

    Solutions For Exercise Sheet 4

    Uploaded by

    Flaminia
    This document provides solutions to an exercise on advanced corporate finance concepts. It analyzes how changes in capital structure would affect metrics like beta, cost of equity, weighted average cost of capital, return on equity, and earnings per share for two pharmaceutical companies, GlaxoSmithKline and Bristol-Myers Squibb. For GlaxoSmithKline, increasing debt and reducing equity is shown to increase beta and cost of equity but leave the WACC unchanged. For Bristol-Myers Squibb, a debt increase is predicted to raise ROE but lower EPS and PE ratios.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd

    Solutions For Exercise Sheet 4

    Uploaded by

    Flaminia
    51 views2 pages
    This document provides solutions to an exercise on advanced corporate finance concepts. It analyzes how changes in capital structure would affect metrics like beta, cost of equity, weighted average cost of capital, return on equity, and earnings per share for two pharmaceutical companies, GlaxoSmithKline and Bristol-Myers Squibb. For GlaxoSmithKline, increasing debt and reducing equity is shown to increase beta and cost of equity but leave the WACC unchanged. For Bristol-Myers Squibb, a debt increase is predicted to raise ROE but lower EPS and PE ratios.

    Original Description:

    exercise present value finance

    Original Title

    Solutions for Exercise Sheet 4

    Copyright

    © © All Rights Reserved

    Available Formats

    DOCX, PDF, TXT or read online from Scribd

    Did you find this document useful?

    Is this content inappropriate?

    This document provides solutions to an exercise on advanced corporate finance concepts. It analyzes how changes in capital structure would affect metrics like beta, cost of equity, weighted average cost of capital, return on equity, and earnings per share for two pharmaceutical companies, GlaxoSmithKline and Bristol-Myers Squibb. For GlaxoSmithKline, increasing debt and reducing equity is shown to increase beta and cost of equity but leave the WACC unchanged. For Bristol-Myers Squibb, a debt increase is predicted to raise ROE but lower EPS and PE ratios.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    51 views2 pages

    Solutions For Exercise Sheet 4

    Uploaded by

    Flaminia
    This document provides solutions to an exercise on advanced corporate finance concepts. It analyzes how changes in capital structure would affect metrics like beta, cost of equity, weighted average cost of capital, return on equity, and earnings per share for two pharmaceutical companies, GlaxoSmithKline and Bristol-Myers Squibb. For GlaxoSmithKline, increasing debt and reducing equity is shown to increase beta and cost of equity but leave the WACC unchanged. For Bristol-Myers Squibb, a debt increase is predicted to raise ROE but lower EPS and PE ratios.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    of 2

    Advanced Corproate Finance, 2019/20

    Advanced Corporate Finance


    Solution to Exercise Sheet 4
    Modigliani Miller, EPS, PE

    GlaxoSmithKline plc (GSK) is global healthcare group. The following numbers are rounded
    numbers from their 2017 financial statements. We assume for simplification that there are no
    taxes.
    a. If the risk free rate is 3% and the market risk premium 6%, what would be an appropriate
    long term annual return for the equity of GlaxoSmithKline, given that the beta of
    GlaxoSmithKline’s equity is 0.6.

    Appropriate return [CAPM] = risk free rate + beta * Market Risk Premium
    =3% + 0.6 * 6% = 6.6%

    The appropriate return for an investment in GlaxoSmithKline’s equity amounts to 6.6%.

    b. GlaxoSmithKline has a total debt level of 20 billion and the market capitalization of the
    company’s equity is 125 billion. The current CEO thinks that the company is under-levered.
    He wants to change the structure of the liabilities by increasing debt to 70 billion and
    reducing the market capitalization to 75 billion. How would this operation affect the
    company’s beta? Please calculate the beta the company’s shares should have after the change
    in capital structure, assuming that the debt is risk free and the company does not pay taxes.

    The company`s asset or unlevered beta will not be affected by this kind of operation as the
    debt beta is considered to be entirely risk free, hence numbers to 0. However, the equity beta
    will increase due to the increase of leverage.

    Calculation of asset beta given the capital structure before the recapitalization:
    = (equity beta *Equity) / Enterprise Value = 0.6 * (125 / 145) = 0,52

    Calculation of equity beta after the recapitalization:


    = (asset beta * Enterprise Value) / Equity = (0.52 * 145) / 75 = 1,00

    c. What should be the cost of equity after the company’s change in capital structure? What
    should be the weighted average cost of capital. Assume that the company pays 3% interest
    before and that bankruptcy risk is negligible even after the change in capital structure.

    Cost of Equity [CAPM] = risk free rate + equity beta * Market Risk Premium
    Cost of Equity (after recapitalization) = 3% + (1,00 * 6%) = 9,00%

    WACC = cost of equity * (Equity / EV) + cost of debt * (Debt / EV)


    WACC (before recapitalization)= 6.6%% * (125 / 145) + 3% * (20 / 145) = 6.1%
    WACC (after recapitalization)= 9,00% * (75 / 145) + 3% * (70 / 145) = 6.1%

    Prof. Michael Troege, ESCP Europe


    Advanced Corproate Finance, 2019/20

    Whereas the cost of equity has been increased due to the increase in leverage, the WACC has
    been unaffected by the recapitalization. This was to be anticipated given the theorems of
    Modgliani & Miller in a scenario without the existence of taxes. With taxes EV would have
    slightly increased and WACC decreased.

    d. The company’s net income is 4,7 billion, there are 2.5billion shares trading at $50. The book
    value of equity is 5.8billion. Please determine ROE and EPS

    Return on Equity = Net Income / Equity


    ROE (based on book value) = 4.7 / 5.8 = 81%
    ROE (based on market value) = 4.7 / (2.5 * 50) = 3.76%

    Earnings per share = Net Income / number of shares


    EPS = 4.7 / 2.5 = 1.88

    e. How will these numbers be affected by the planned recapitalization? Assume that the
    company buys back shares at the current market price.

    We know that EPS numbers go up with leverage in case earnings yield=1/PE>rD. (see class
    or extra reading on the supplement section of Blackboard) This is the case here as the
    earnings yield is 4,7/125=3,7%.
    We also know that leverage increases ROE in case EBIT/ Book Assets=ROA>rD.
    In this case we have EBIT ≈ 4,7+20*0,03=5,3 and Book Assets ≈ Book Value of Equity +
    Debt =25,8, hence ROA=5,3/25,8=20,5%>rD, hence the operation will increase ROE.

    f. Bristol-Myers Squibb Co. another healthcare group, has the following key financials: Net
    Income : 2.5billion; Shareholders Equity (book value): 15billion; Market Capitalization:
    97billion; Number of shares outstanding : 16billion; Total (book) assets 38billion; EBIT 2,8
    billion. Use these numbers to quickly identify the qualitative effects of 30billion increase in
    debt on ROE, PE and EPS.

    ROE (based on book value) = NI/SHE = 16.91%


    ROA= 2,8/38=7,3% this is likely higher than cost of debt, hence the operation will increase
    ROE
    PE = Market Cap/NI = 37.91 ,hence earnings yield is only 1/37,9=2,6%. This is likely to be
    lower than the (tax adjusted) interest rate, hence the operation will decrease EPS
    EPS = NI/# Shares = 1.54

    Prof. Michael Troege, ESCP Europe

    You might also like