FINA2222 Corporate Financial Policy 2024 Sem 1

You noted that your firm’s market value of common equity was more than $15 billion, recently traded at $15.69 per share (a 76.2% increase from the year before).You also discussed with the CFO the current capital-market conditions and decided to focus on the assumption that the firm could borrow up to $10 billion at a credit rating of AA or AAA in the current market.

Below is some relevant information about the company you’ve collected from your research:

Company overview

Ndivia  is  currently  a  leading  global  manufacturer  of  high-end  graphics  processing  units (GPUs). The firm’s industry, technology, was intensely competitive and was dominated by a few large players, Intell, AND, CISKO, to name a few. Its revenues and earnings had grown substantially  in  the   past  five  years,  thanks  to  a  strong  drive  to  develop  AI  related technologies since the foundation of OpenAI in 2015 by Sam Altman, Greg Brockman, Peter Thiel, Elon Musk, and others. (Exhibit 1: Income Statement in Excel). Historically, the firm had been conservatively financed. At the end of 2023, it had total assets just under $1.9 billion and no long-term debt (Exhibit 2: Balance Sheet in Excel). Ndivia’sstock price (Exhibit 4: Other Information in Excel) had significantly outperformed the S&P 500 composite index and was running slightly ahead of its industry index.

Estimating the effect of leveraged recapitalization

Under the proposed leveraged recapitalisation, Ndivia could borrow up to $10 billion and use it either to pay an equivalent dividend or to re-purchase an equivalent value of shares. You knew that this combination of actions could affect the firm’s value, share price, cost of capital, debt coverage, and profitability. Accordingly, you thought to evaluate the effect of therecapitalisation from these aspects.

•    The effect on valuation and share price

You recalled that debt increased the value of a firm by means of shielding cash flows from taxes. Thus, the  present  value  of  debt  tax  shields  could  be  added  to  the  value  of  the underlying unlevered firm to yield the value of the levered enterprise. The marginal tax rate proposed to use was 25%, reflecting the sum of federal, state and local taxes.

•    The effect on the cost of capital

You also knew that the maximum value of the firm was achieved when the weighted average cost of capital (WACC) was minimised. Thus, you intended to estimate what the cost of equity (rE) and the rWACC might be if Ndivia pursued this capital structure change. The projected cost of debt (rD) would depend on the assessment of the firm’s debt rating, AA, given the current capital market rates (Exhibit 3: Credit Rating in Excel).

The cost of equity (rE) could be estimated the capital asset pricing model (CAPM). Exhibit 3 gives yields on U.S. Treasury instruments which afforded possible estimates of the risk-free return (rf) and the equity market risk premium (rm – rf) of 7%. Exhibit 4 gives BT’s current (unlevered) beta.

•    The impact on reported earnings per share

You intended to estimate the expected effect on earnings per share (EPS) that would occur at different levels of operating income (EBIT) with a change in leverage. You planned to draw a graph to illustrate this effect.

• Other effects

Lastly, you wondered whether your analysis covered everything. Where, for instance, should you consider potential costs of bankruptcy and distress or the effects of leverage as the signal for future  operations  of the  company?  More  leverage  would  also  create  certain constraints or incentives for management. Should those be also included in the report for consideration?

Questions to help preparing the report:

To prepare a formal report based on your above understanding so far, you have outlined the following questions to be addressed, providing answers that will serve as the foundation for your report.  In  this  report,  you  will  present  theories  and  supporting  evidence from  the company’s financial statements to evaluate whether the company should pursue a leveraged recapitalization.

Question 1 (Q1) Base case: the MM theory of capital structure

In perfect capital markets, what is the relationship between capital structure and cost of capital  (WACC)?  Apply  the  famous  Miller-Modigliani  propositions  to  Ndivia’s  case  and explain how a different capital structure mayor may not affect its market value.

Tips:

1.   Complete the table in Excel spreadsheet Q1 Perfect Mkt.

2.   Draw a chart using debt level (D) against rE and  WACC to support the discussion of MM proposition I and II. (Paste the chart in appendix.)

3.   Show your calculations for each variable in row (6) to (15) using debt = $7 billion in a MS Word document.

4.   Provide a succinct discussion based on your analysis.

Question 2 (Q2) The effect of leverage on the firm’sshare price (with corporate tax)

To test the valuation effect of leverage, you assume that Ndivia plan to borrow $7 billion at a pre-tax cost of debt, determined based on the firm’s current AA credit rating, and that the aggregate amount of debt will remain constant in perpetuity.  Also, you assume that the proceeds of the  loan would  be  used  to  repurchase  shares or  pay  a  special  dividend to shareholders.

What is the amount of tax benefit, i.e., the present value of interest tax shields (ITS)? How does Ndivia’s debt, equity, market value, number of shares outstanding and price per share change  in  the  four-stage  process,  that  is,  pre-recapitalization   (or  current),   at   the announcement of debt issuance, when debt is issued, and after the fund is spent on either repurchasing shares, or paying a lumpsum of special dividend?

Tips:

1.   Complete tables a and bin Excel spreadsheet Q2 Valuation & Q3 WACC.

2.   Show your calculations in a MS Word document.

3.   Provide a succinct discussion based on your analysis.