Financial Management Tutorial

Ch.14 &16 Cost of Capital, WACC, EBIT-EPS Analysis

Problem 1 ch 14
The manager of PT RAB is considering the rate of return that will be offered to its creditors.
Here is the information of PT RAB:
PT RAB has issued 6000 shares of bond with par value of Rp 1.000.000,- and sold at 8% premium. After tax
cost of debt of this bond is 7,5%. PT RAB also issued common and preferred stock. The number of common
stock outstanding is 7.500.000 shares with price of Rp 2.500,- per share and beta of 1,3. The preferred stock
outstanding is 9.000.000 shares with dividend of Rp 1.000,- and sold at the price of Rp 10.000. Market return
is 8%, SBI rate is 6,5% and the tax rate is 35%. How much the rate of return PT RAB has to offer to attract the
investors?

Problem 2 ch 14
Given the following information for Alexandria Power Company, find the WACC. Assume the company’s tax
rate is 35%.
Debt : 4,000 7% coupon bonds outstanding, EGP 1,000 par value, 20 years to maturity,
selling for 103 % of par, the bonds make semiannual payments
Common Stock : 90,000 shares outstanding, selling of EGP 60 per share ; the beta is 1,1
Preferred stock : 13,000 shares of 6% preferred stock outstanding, currently selling for EGP 110 per share
Market : 8% market risk premium and 6% risk free rate

Problem 3 ch 14
Romania Alliance company is considering a project that will result in initial aftertax cash savings of 4.0 million
lei at the end of the first year, and these savings will grow at a rate of 5% per year indefinitely. The firm has a
target debt-equity ratio of 0,65, a cost of equity 15%, and an aftertax cost of debt 5,5%. The cost saving proposal
is somewhat riskier than the usual project the firm undertakes ; management uses the subjective approach and
applies an adjustment factor of +2% to the cost of capital for such risky projects. Under what circumstances
should Romania take on the project?

Problem 4 ch 16
Shantou beverage is comparing two different capital structures, an all equity plan (plan I) and a levered plan
(plan II). Under plan I, Malang would have 150,000 shares of stock outstanding. Under Plan II, there would be
60,000 shares of stock outstanding and 15 million rupiahs in debt outstanding. The interest rate on the debt is
10% and there are no taxes.
a. If EBIT is 2 million rupiahs, which plan will result in the higher EPS?
b. If EBIT is 7 million rupiahs, which plan will result in the higher EPS?
c. What is break-even EBIT?

Problem 5 ch 16
Money SpA, has no debt outstanding and a total market value of $150,000. Earnings before interest and taxes,
EBIT, are projected to be $15,000 if economic conditions are normal. If there is strong expansion in economy,
then EBIT will be 30% higher. If there is a recession, then EBIT will be 60% lower. Money is considering a
$60,000 debt issue with a 5% interest rate. The proceeds will be used to repurchase shares of stock. There are
currently 2,500 shares outstanding. Ignore taxes for this problem.
a. Calculate earnings per share, EPS, under each of the three economic scenarios before any new debt is
issued. Also, calculate the percentage changes in EPS when the economy expands or enters a recession.
b. Repeat part (a) assuming that Money goes through with recapitalization. What do you observe?

Problem 6 ch 16
Natal Tool Manufacturing, a firm based in Brazil, has an expected EBIT of 75,000 reals in perpetuity and a tax
rate of 35%. The firm has 150,000 reals in outstanding debt at an interest rate of 9%, and its unlevered cost of
capital is 14%. What is the value of the firm according to M&M Proposition I with taxes? Should Natal change
its debt-equity ratio if the goal is to maximize the value of the firm? Explain!
 Financial Management Tutorial
Ch.14 &16 Cost of Capital, WACC, EBIT-EPS Analysis
Problem 1 ch 14
The manager of PT RAB is considering the rate of return that will be offered to its creditors.
Here is the information of PT RAB:
PT RAB has issued 6000 shares of bond with par value of Rp 1.000.000,- and sold at 8% premium. After tax
cost of debt of this bond is 7,5%. PT RAB also issued common and preferred stock. The number of common
stock outstanding is 7.500.000 shares with price of Rp 2.500,- per share and beta of 1,3. The preferred stock
outstanding is 9.000.000 shares with dividend of Rp 1.000,- and sold at the price of Rp 10.000. Market return
is 8%, SBI rate is 6,5% and the tax rate is 35%. How much the rate of return PT RAB has to offer to attract the
investors?

Problem 2 ch 14
Given the following information for Alexandria Power Company, find the WACC. Assume the company’s tax
rate is 35%.
Debt : 4,000 7% coupon bonds outstanding, EGP 1,000 par value, 20 years to maturity,
selling for 103 % of par, the bonds make semiannual payments
Common Stock : 90,000 shares outstanding, selling of EGP 60 per share ; the beta is 1,1
Preferred stock : 13,000 shares of 6% preferred stock outstanding, currently selling for EGP 110 per share
Market : 8% market risk premium and 6% risk free rate

Problem 3 ch 14
Romania Alliance company is considering a project that will result in initial aftertax cash savings of 4.0 million
lei at the end of the first year, and these savings will grow at a rate of 5% per year indefinitely. The firm has a
target debt-equity ratio of 0,65, a cost of equity 15%, and an aftertax cost of debt 5,5%. The cost saving proposal
is somewhat riskier than the usual project the firm undertakes ; management uses the subjective approach and
applies an adjustment factor of +2% to the cost of capital for such risky projects. Under what circumstances
should Romania take on the project?

Problem 4 ch 16
Shantou beverage is comparing two different capital structures, an all equity plan (plan I) and a levered plan
(plan II). Under plan I, Malang would have 150,000 shares of stock outstanding. Under Plan II, there would be
60,000 shares of stock outstanding and 15 million rupiahs in debt outstanding. The interest rate on the debt is
10% and there are no taxes.
a. If EBIT is 2 million rupiahs, which plan will result in the higher EPS?
b. If EBIT is 7 million rupiahs, which plan will result in the higher EPS?
c. What is break-even EBIT?

Problem 5 ch 16
Money SpA, has no debt outstanding and a total market value of $150,000. Earnings before interest and taxes,
EBIT, are projected to be $15,000 if economic conditions are normal. If there is strong expansion in economy,
then EBIT will be 30% higher. If there is a recession, then EBIT will be 60% lower. Money is considering a
$60,000 debt issue with a 5% interest rate. The proceeds will be used to repurchase shares of stock. There are
currently 2,500 shares outstanding. Ignore taxes for this problem.
a. Calculate earnings per share, EPS, under each of the three economic scenarios before any new debt is
issued. Also, calculate the percentage changes in EPS when the economy expands or enters a recession.
b. Repeat part (a) assuming that Money goes through with recapitalization. What do you observe?

Problem 6 ch 16
Natal Tool Manufacturing, a firm based in Brazil, has an expected EBIT of 75,000 reals in perpetuity and a tax
rate of 35%. The firm has 150,000 reals in outstanding debt at an interest rate of 9%, and its unlevered cost of
capital is 14%. What is the value of the firm according to M&M Proposition I with taxes? Should Natal change
its debt-equity ratio if the goal is to maximize the value of the firm? Explain!
Jawaban:

Problem 1
MVD = 6,000 (1.08) (Rp 1,000,000) = Rp 6,480,000,000 5.62%
MVE = 7,500,000 (Rp 2,500) = Rp 18,750,000,000 16.27%
MVP = 9,000,000 (Rp 10,000) = Rp 90,000,000,000 78.10%
Total MV Rp 115,230,000,000 100%

RE = 0.065 + 1.3 (0.08 – 0.065) = 0.0845 atau 8.459%

RP = Rp 1,000/Rp 10,000 = 0.1 atau 10%
WACC = 5.62%(7.5%) + 16.27%(8.45%) + 78.10%(10%) = 0.096063 = 9.6%

Problem 2

We will begin by finding the market value of each type of financing. We find:

MVD = 4,000(EGP 1,000)(1.03) = EGP 4.12M

MVE = 90,000(EGP 60) = EGP 5.40M
MVP = 13,000(EGP 110) = EGP 1.430M

And the total market value of the firm is:

V = EGP 4.12M + 5.40M + 1.430M = EGP 10.95M

Now we can find the cost of equity using the CAPM. The cost of equity is:
RE = .06 + 1.10(.08) = .1480 or 14.80%

The cost of debt is the YTM of the bonds, so:

P0 = EGP 1,030 = EGP 35(PVIFAR%,40) + EGP 1,000(PVIFR%,40)
R = 3.36%
YTM = 3.36% × 2 = 6.72%

And the aftertax cost of debt is:

RD = (1 – .35)(.0672) = .0437 or 4.37%

The cost of preferred stock is:

RP = EGP 6/EGP 110 = .0546 or 5.46%

Now we have all of the components to calculate the WACC. The WACC is:
WACC = .0437(4.12/10.95) + .1480(5.40/10.95) + .0546(1.43/10.95) = 9.57%

Notice that we didn’t include the (1 – tC) term in the WACC equation. We simply used the aftertax cost of debt in the
equation, so the term is not needed here.
Problem 3
Using the debt-equity ratio to calculate the WACC, we find:
WACC = (.65/1.65)(.055) + (1/1.65)(.15) = .1126 or 11.26%

Since the project is riskier than the company, we need to adjust the project discount rate for the additional risk. Using
the subjective risk factor given, we find:
Project discount rate = 11.26% + 2.00% = 13.26%

We would accept the project if the NPV is positive. The NPV is the PV of the cash outflows plus the PV of the cash
inflows. Since we have the costs, we just need to find the PV of inflows. The cash inflows are a growing perpetuity.
If you remember, the equation for the PV of a growing perpetuity is the same as the dividend growth equation, so:

PV of future CF = PHP 4,000,000/(.1326 – .05) = PHP 48,440,367

The project should only be undertaken if its cost is less than PHP 48,440,367 since costs less than this amount will
result in a positive NPV.

Problem 4

a. Under Plan I, the unlevered company, net income is the same as EBIT with no corporate tax. The EPS under this
capitalization will be:
EPS = CNY2,000,000/150,000 shares
EPS = CNY13.33

Under Plan II, the levered company, EBIT will be reduced by the interest payment. The interest payment is the
amount of debt times the interest rate, so:
NI = CNY2,000,000 – .10(CNY15,000,000)
NI = CNY500,000

And the EPS will be:

EPS = CNY500,000/60,000 shares
EPS = CNY8.33

Plan I has the higher EPS when EBIT is CNY2,000,000.

b. Under Plan I, the net income is CNY7,000,000 and the EPS is:
EPS = CNY7,000,000/150,000 shares
EPS = CNY46.67

Under Plan II, the net income is:

NI = CNY7,000,000 – .10(CNY15,000,000)
NI = CNY5,500,000

And the EPS is:

EPS = CNY5,500,000/60,000 shares

EPS = CNY91.67

Plan II has the higher EPS when EBIT is CNY7,000,000.

c. To find the breakeven EBIT for two different capital structures, we simply set the equations for EPS equal to each
other and solve for EBIT. The breakeven EBIT is:
EBIT/150,000 = [EBIT – .10(CNY15,000,000)]/60,000
EBIT = CNY2,500,000
Problem 5

a. A table outlining the income statement for the three possible states of the economy is shown below. The EPS is
the net income divided by the 2,500 shares outstanding. The last row shows the percentage change in EPS the
company will experience in a recession or an expansion economy.

Recession Normal Expansion

EBIT €6,000 €15,000 €19,500
Interest 0 0 0
NI €6,000 €15,000 €19,500
EPS € 2.40 € 6.00 € 7.80
%EPS –60 ––– +30

b. If the company undergoes the proposed recapitalization, it will repurchase:

Share price = Equity / Shares outstanding
Share price = €150,000/2,500
Share price = €60

Shares repurchased = Debt issued / Share price

Shares repurchased =€60,000/€60
Shares repurchased = 1,000

The interest payment each year under all three scenarios will be:
Interest payment = €60,000(.05) = €3,000

The last row shows the percentage change in EPS the company will experience in a recession or an expansion
economy under the proposed recapitalization.
Recession Normal Expansion
EBIT €6,000 €15,000 €19,500
Interest 3,000 3,000 3,000
NI €3,000 €12,000 €16,500
EPS €2.00 € 8.00 €11.00
%EPS –75.00 ––– +37.50

Problem 6
To find the value of the levered firm we first need to find the value of an unlevered firm. So, the value of the unlevered firm
is:
VU = EBIT(1 – tC)/RU
VU = (BRL75,000)(1 – .35)/.14
VU = BRL348,314.29

Now we can find the value of the levered firm as:

VL = VU + tCD
VL = BRL348,314.29 + .35(BRL150,000)
VL = BRL400,714.29
Applying M&M Proposition I with taxes, the firm has increased its value by issuing debt. As long as M&M
Proposition I holds, that is, there are no bankruptcy costs and so forth, then the company should continue to increase
its debt/equity ratio to maximize the value of the firm.