Question 1 [30]

Two companies, Wheels Ltd and Drive (Pty) Ltd, are entities within the transport industry. They are competitors specializing in providing car rental services. Both companies are exposed to the same business risk and both were all-equity-financed companies. In 2020, Wheels Ltd expanded its fleet and financed the expansion using debt finance.

The companies have the following capital structures: Drive (Pty) Ltd		Wheels Ltd
Book value of equity	3 000 000	3 500 000
Market value of equity	4 000 000	8 000 000
Book value of debt		2 000 000
Market value of debt		2 000 000
Issued shares	9 000 000	8 000 000
Current dividends	800 000	650 000
Cost of equity capital (ke)	12%	14%

Additional information:

The tax rate is 28%.

The current market cost of debt is 13%.

The market value of one share in Wheels Ltd is R1.00.

Required

1.1. In your opinion, did the business risk profile of Wheels Ltd change when it acquired debt finance? Provide reasons for your answer. The reasons must very clearly specify the causes for the business risk changing or remaining unchanged. (4)

1.2. Use the information provided to calculate the weighted average cost of capital (WCC) for both companies. (8)

1.3. Based on the results of 1.2, are the companies capital structures aligned to the traditional or the Miller and Modigliani capital structure theory? Provide reasons for your answer. (4)

1.4. Basing their concerns on the Miller and Modigliani approach, Wheels Ltds shareholders are of the opinion that they are not adequately compensated anymore for business risk compared with Drives shareholders. They requested your assistance with the calculations needed to prove their concerns that they are not adequately compensated for holding shares in Wheels Ltd. Use a shareholder holding one share in Wheels Ltd and willing to purchase one Driver share as the basis for your calculations. Show all calculations and round off all calculations to the nearest rand. (14)