B392 Online Tutorial 3 Session will begin at 7 B392 Online Tutorial 3 Session will begin at 7.00pm You will need access to the activities posted to forum and a calculator

Online Tutorial 3 Agenda Activity 1: YGV Inc Bond valuation, the WACC and sources of finance 40 mins Activity 2: Katmai Inc Interest rate risk and swaps 15 mins TMA 02 5 mins

Online Tutorial 3 learning objectives Understand and explain how to calculate the cost of debt and equity; Understand and explain how to calculate the weighted average cost of capital (WACC); Understand bond valuation; Explain bond yields and the relationship between bond price and yield; Explain and evaluate interest rate risk; Understand how to use a case study in TMA02/ B392

Activity 1: Bond valuation Case study: YGV Inc Identify key points Post some points into text chat http://www.istockphoto.com/photo/mighty-percent-of-litecoins-36901644?st=cdb1bf6 4

Case study:YGV Massive fall in PBIT over past year. Reasons? Implications? What is current gearing? How is interest coverage calculated?

Part a: Bond valuation INSERT calculator and pen image 6

Part a: Bond valuation Bond issue? Calculate after-tax cost of debt of the 9% bonds? Find the internal rate of return of 9% bonds (after-tax) Find the internal rate of return using the interpolation method 7

Part a: Bond valuation Interpolation formula: See formula pg 41 unit 4 text. Also graph pg 35 unit 4 text Note - After-tax interest payment = $9 x (1 – 0.30) = $6.30 per bond First identify the cash flows. What are these? What would be a sensible choice for the interest rate to use to discount cash flows? 8

Part a: Bond valuation NPV at 8% is positive. Should we now choose a higher or lower interest rate to discount? Generally we would choose a higher discount rate but because the cash flows are unusual, with an cash inflow in year 0 and then cash outflows we need to choose a lower discount rate. 9

Part a: Bond valuation What will the approximate IRR be? 10

Part a: Bond valuation Interpolation formula: 6 + [(8 – 6) x (7.75)/((7.75) - 6.80)] = 6 + 1.10 = 7.10% 11

Part b: WACC If you are asked to calculate the effect on the WACC you need to calculate The current WACC The new WACC Comment on the difference What is the current WACC? 12

Part b: WACC It depends on whether the overdraft is considered to be long term finance. What do you think? 13

Part b: WACC State your assumptions. Current market capitalisation = 10m x $4.10 = $41m Overdraft = $4.5m If overdraft is long term finance (reasonable assumption here) Then gearing is Debt 10% approx(4.5/41+4.5) Equity 90% approx (41/41+4.5) 14

Part b: The WACC WACC = D/D+E x Rd x (1-T) + E/D+E x Re = debt gearing x cost of debt + equity gearing x cost of equity = 0.10 x 0.05 x (1-0.30) + 0.90 x 0.12 = 0.0035 + 0.108 = 0.1115 or 11.15% Note that without any debt, the WACC would be the same as the current cost of equity, which is 12%. What is the new WACC? 15

Part b: The WACC WACC = D/D+E x Rd x (1-T) + E/D+E x Re = debt gearing x cost of debt + equity gearing x cost of equity = 0.10 x 0.05 x (1-0.30) + 0.90 x 0.12 = 0.0035 + 0.108 = 0.1115 or 11.15% Note that without any debt, the WACC would be the same as the current cost of equity, which is 12%. What is the new WACC? 16

Part b: The WACC First calculate new gearing. What is this? Then find cost of debt and equity. What are these? Then put figures into the formula. You try and post your solutions into text chat 17

Part b: The WACC New gearing is Debt 9% approx(4 /41+4) Equity 91% approx (41/41+4) Cost of debt is 7.1% from part a Cost of equity remains at 12% (How realistic is this?) 18

Part b: The WACC WACC = D/D+E x Rd x (1-T) + E/D+E x Re = debt gearing x cost of debt + equity gearing x cost of equity 0.09 x 0.071 + 0.91 x 0.12 0.0064 + 0.1092 0.1156 or 11.56% How has this changed compared to the current situation? Why? Is it realistic that cost of equity would remain unchanged? 19

Part c: Interest coverage Current interest = $4.5 m x 5% = $225,000 per year Current interest coverage ratio = 1m/0.225 = 4.44 times Interest from bond issue = $4m x 9% = $360,000 per year Revised interest coverage ratio = 1m/0·360 = 2·78 times Comments? 20

Part c: Gearing Market capitalisation of YGV Inc. = 10 m shares x $4·10 = $41 million Current gearing using market values, excluding overdraft = zero or 11% with overdraft Revised gearing using market values, after bond issue, = 4,000/41,000 = 9.76% NB Note different formula for gearing used to be able to compare with sector average Comments? 21

Part d: Evaluate sources of finance Spend 3 minutes reviewing the information. Evaluate the proposal. What points to include? Alternative sources of finance. Suggestions? Post your ideas 22

Part d: Evaluate sources of finance Investor perception (shareholders and prospective debt holders)? Collateral required? Overdraft as a source of finance? Future? 23

Part d: Evaluate sources of finance Alternatives? Equity – rights issue? Sale and leaseback? Convertible bonds? Improve working capital management ? 24

Activity 2: Interest rate risk What is interest rate risk? How can interest rate risk be managed?

Activity 2: Interest rate risk Interest rate risk is the risk that the value of the company will change as a result of changes in interest rates Manage by assessing exposure and: Do nothing, OR Change source of finance/ investment, OR Maintain source of finance/ investment and use a complementary financial instrument (financial derivative)

Activity 2: Interest rate risk Summarise Katmai case What are the key points?

Activity 2: Interest rate risk What are: Floating-rate notes Basis points LIBOR

Activity 2: Interest rate risk Example of yield curve from Unit 3

Part a: Alternative choices Do nothing…. Depends on - risk attitude of management - diversification in international market - magnitude of interest costs

Part a: Alternative choices Issue fixed rate bonds and buy back floating-rate notes… This will reduce risk but is expensive. Arrangement fees, underwriting costs are 2-3% of the value of the loan

Part a: Alternative choices Use a derivative….how can Katmai use an interest rate swap?

Part a: Interest rate risk Reminder of swap diagram from Unit 3 with swap cash flows and original borrowing

Part a: Interest rate risk Katmai is paying a variable rate, when LIBOR rises, so will Katmai’s interest costs. Katmai may chose to ‘swap’ the variable rate paid in order to pay a fixed rate. A fixed rate will give certainty about interest costs in a rising interest rate scenario. Of course, interest rates may not rise as indicated in the yield curve…

Part b: Estimating interest rate 10 - year swap rates are quoted at 5.25 – 5.40. These are fixed rates. Note that bank sells high and buys low so bank sells money (lends at 5.40%) and buys money (borrows) at 5.25%.

Part b: Interest rate risk If entering into a swap, Katmai will want to receive a variable rate (to negate variable rate that it is paying at present) and pay a fixed rate so will pay 5.40% and receive LIBOR Pays 5.4 % Company Bank (market maker) Receives LIBOR Pays LIBOR plus 1.2% Investors

Part b: Interest rate risk The cost to Katmai will be 5.40% plus 1.20% or 6.60%. The six monthly interest rate under a vanilla swap given the quoted spread would be 6.60%/2 = 3.3% The six-monthly rate is 3·30% or an effective annual rate: EAR = 1·03302 – 1 = 6·71%

Activity 3 Toyco I will send model answers to this question with the tutorial slides and hope that you will have an opportunity to discuss these in your tutor group forums

B392 case study guidance Have you? Considered the broader setting of the case Considered the source of information as presented in the case (often there is disagreement between different people in the case study, who have different perspectives) Balanced your technical knowledge to reflect the constraints that may appear in the case. That is, the theoretically best approach may not work in every organisation. The key features of using a case study for summative assessment at level three is that it requires students to extract relevant information from a longer description rather than being simply presented with numbers in isolation. It also allows for the situation to be ambiguous and allows them to question the objectivity of the information presented. It is a small step towards providing a more realistic situation for them to analyse. With this in mind things to look for are that the student has:

Online Tutorial 3 learning objectives Understand bond valuation; Explain bond yields and the relationship between bond price and yield; Explain and evaluate interest rate risk; Understand how to use a case study in TMA02/ B392

End of online tutorial 3