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Solution – QUESTION 2 (written by Asher Curtis) - 10 Marks Suggestions only: 1. (3 marks for identifying the three dimensions) Applications of cost and equity differ on three dimensions. First, the treatment of dividends, is written against the investment account (Equity) or recognised as revenue (Cost). Second, the treatment of profits reported by the associated entity and the ammortisation of goodwill (the difference in the cost paid and the fair value of the net assets acquired) are not recognised when applying the cost method. The only case where net profit is not affected by choice of the method is where there is no goodwill (cost = fair value of net assets acquired) and the firm pays out all of its profit as dividends. Any of the following alternatives provide examples (2 marks for any of the following): a. The case for a profitable company that pays less than 100% profits out as dividends: The net value of the investment increases under the equity method, which will be more than cost unless the investment is revalued. b. The case for a loss company that pays no dividends: Unless the investment is subject to a recoverable amount test, application of the equity method

The airlines and trucking industry were the clearest almost total price and entry regulation cases. Until 1977 the air fares and route structures were severely regulated by the Civil Aeronautics Board (CAB) and similarly heavy transport was regulated by the Interstate Commerce Commission (ICC). Often, authorizing that competitors offer their services on specific routes, but price competition was impeded by price regulation based on average costs across the industry. Theoretical research on regulations in these industries, conducted in the

1. There are a few trends in the US airline industry. One is consolidation, wherein existing players merge in an attempt to lower their costs and generate operating synergies. The most recent major merger was the United Continental merger, which is still an ongoing affair, but has created the largest airline in the United States by market share (Martin, 2012). Another trend is towards low-cost carriers. In the US, Southwest has been a long-running success and JetBlue a strong new competitor, but in other countries this business model has proven exceptionally successful. The third major trend is the upward trend in jet fuel prices, and the increasing importance that this puts on hedging fuel prices and capacity management (Hinton, 2011).

Throughout the development of the United States and its economy, transportation has been the catalyst as well as sometimes the prohibitor of growth from industry to industry and region to region. As supply chains have become more globalized, so has the need for a more efficient and accessible transportation infrastructure within the country to allow greater access to newer markets overseas. By having such a crucial role in U.S commerce over the years, there has been fluctuations in the amount of regulation drawn up by the government and enforced by federal agencies and the courts. In this case, the railroad, trucking and air industry’s have reflected the national trends of regulation and deregulation movements over the last 15 years.

Regulations imposed on the motor carrier industry have two sided effects on the US economy. The motor carrier industry is a vital aspect of the US economy, transporting goods all across the world. First let’s explore the term regulation this is a law or rule placed into effect by the Federal Motor Carrier Safety Administration (FMCSA) this administration creates and implements the regulations for various reasons, safety, driver qualifications, hours of service, fuel costs and fuel standards and emissions. As with anything when enough restrictions are applied the effects often mean a loss in economic growth. After 9/11 the transportation industry was

The effect of financial leverage on the cost of equity is prevalent in the Modigliani-Miller capital structure theory. Since the financial leverage increases the cost of equity, it can be considered one of the disadvantages of borrowing. As shown in Appendix A, the cost of equity, at each debt to capital ratio, increases by 0.1% as the financial leverage increases by 10%. With a higher

Although the increased leverage decreases the amount of earnings available to stock holders from 496.9 million to 451.7 million for a total of 45.2 million dollars, it has a positive affect for the company’s tax structure. It actually reduces the company’s tax liability by 83 million dollars! Without the debt they have to pay 952.5 million dollars in taxes. However after an increase of 30% leverage, the new tax liability is 869.5 million dollars.

In a market with taxation, the value of the levered firm equals to the value of the unlevered firm plus the present value of interest tax shield.

Dilution of shares seems have to have little impact on the EPS of PG shares. Therefore, it is expected that PG shareholders would accept the issuing of shares. However, this information has to be clearly communicated by PG's management to its shareholders in order to gain

Generally, firms can choose among various capital structures in order to maximize overall market value of the company. It is proposed however, that

When corporate taxes are taken into consideration, the value of a firm increases linearly with debt-equity ratio because of interest payments being tax exempted. M-M’s work has been at the centre stage of the

It seems then that companies should fully leverage the company or a least come close to doing so but there is a probability that the company enters financial distress as its leverage (D/E) increases. Financial distress can be very costly for companies, and the cost for this scenario is shown in the current market value of the levered firm's securities. Investors factor the potential for future distress into their assessment of the present value (this is where PV of distress costs is subtracted from un-levered company value and the PV of the tax-shield.) The value for the costs

According to the Equilibrium Theory, at the optimal leverage point the PV of tax expense should be equal to the financial distress costs. Simpson and Williams’ simulation model helped us to find the point, at which point the EBIT/Interest was equal to 2.8. However, financial model does not stand for the real world. The interest coverage of 2.8 is not suitable for Diageo, because there are many defects in the simulation model.

From this set of problems, we can see that leverage is good for the firm. Leverage has increased the value of the firm as a whole and increased the price per share. Although the cost of debt increases the firm's risk because it increases the probability of default and bankruptcy, therefore shareholders will require higher rates of return on the equity they provide, debt also provides tax savings. And we can see that in table 4, where we calculated the total value of the firm as the pure business cash flows plus the tax savings. Another reason why debt increases firm value is the fact that it reduces WACC, because the cost of debt is generally lower than the cost of equity. Another option that shareholders can do is using homemade leverage. Shareholders should pay a premium for the shares of a levered firm when the addition of debt increases value.

Also, the stock market tends to react negatively to announcements of new common stock offerings, whereas debt security announcement tend to have little impact on stock prices. As a additional external financing is needed, the firm will work down the pecking order – from safe to more risky debt, then possibly to convertible debt, and finally to common equity as a last resort.