QUESTION

Part A

Every time a listed company does a share buyback, media and investors alike would debate fiercely on the merits of such a scheme. There are investors who prefer buybacks to high dividends payments and vice versa. Proponents of both schemes point to share price increases as their proof that such schemes increase shareholder value.

Required:

Decribe whether shareholders' value is increased not by a change in financial structure or dividend policies but by a more fundamental factor based on information asymmetry.

Part B

I. Hose plc presently has a capital structure which is 30 per cent debt and 70 percent equity. The cost of debt (i.e. borrowings) before taxes is 9 percent and that of equity is 15 percent. The firm's future cash flows, after tax but before interest, are expected to be perpetuity of Rs. 750,000. The tax rate is 30 per cent.

Required:

Determine the weighted average cost of capital and the value of the firm.

II. The Directors are considering the partial replacement of equity finance with borrowings so that the borrowings make up 60 per cent of the total capital. Director A believes that the cost of equity capital will remain unchanged at 15 per cent; Director B believes that shareholders will demand a rate of return of 23.7 per cent; Director C believes that shareholders will demand a rate of return of 17 per cent.

Following the assumption that the cost of borrowings before income taxes remains at 9 per cent.

Required:

Determine the weighted average cost of capital and the value of the firm under each of the director's estimates.