Finance Tutorial 7

Question 1:

Schuldenfrei AG pays no taxes and is financed entirely by equity. The aggregate value is £100 million,
there are 2 million shares outstanding, and operating profits over the last 12 months were £10
million. There is no working capital. Each share costs £50, the equity beta is 0.7, and the expected
return on equity is 10%. Schuldenfrei now decides to repurchase half the common stock and finance
the repurchase by issuing debt. There are no taxes. If the debt yields a risk-free 6 percent, calculate:

a. The equity beta after the refinancing.

No tax so there is no value added from a tax shield. Thus value remains the same.

V = 100

Risk free debt so beta debt = 0

No taxes so after restructure,

Ba = D/V*Bd + E/V*Be = 0.5*Be,after

Now ra stays the same as no taxes so Ba is the same as when full equity.

Ba = Be,before = 0.7

So Be,after = Ba * 2 = 1.4

b. The expected return on equity after the refinancing.

rpm = (rbefore – rf)/Be,before + rf = 11.7%

re,after = rf + Be,after * rpm -rf= 6+(11.7-6)*1.4 = 13.98%

Assume that the operating profit of the firm is expected to remain constant in perpetuity. Calculate:
c. The percentage increase in expected earnings per share.

Rwacc = rd*D/V + re*E/V = 0.5*13.98+0.5*6 = 9.99%

Value = profit/rwacc 7

Profit = Value * Rwacc = 0.1*100 = 10 million.

New number of shares = 1 million

EPSafter = 10/ 1 = 10

So 100% increase

d. The new price-earnings multiple

P/E = 50/10 = 5
Question 2:

re = rf + Be*(rm-rf) = 22%

Bd = (rd -rf)/(rm-rf) = 0.25

ra = D/V*rd + E/V*re = 0.5*(22+12) 17%

Ba = D/V*Bd + E/V*Be = 0.5*(1.75) = 0.875

3. BG has an equity beta of 0.9 and a leverage ratio of 50%. It rebalances its debt to keep a constant
leverage ratio. Assume that the debt of BG is risk-free and that BG has a marginal tax rate of 25%.
The risk-free rate is 2% and the market risk premium is 5%.

a. What is BG’s after-tax WACC?

re = rf + B*(rpm – rf) = 2+0.9*(5) = 6.5%

rwacc = D/V*rd*(1-t) + re*E/V = 0.5*(1-0.25)*0.02 + 0.065*0.5 = 4%

b. What is the after-tax WACC if the leverage ratio increases to 0.7 and the beta of debt is 0.1?

D/V = 0.7
E/V = 0.3

Initially,
ra,1 = (D/V)1*rd,1 + (E/V)1*re,1 = 2*0.5+0.5*6.5 = 4.25%

Now after leveraging, ra is unlevered so stays the same. Leveraging affects r d & re. Call this scenario 2

rd,2 = rf + rpm*Bd,2 = 2+0.1*5= 2.5%

As ra is the same, ra,2 = ra,1 = 4.25%

ra,2 = (D/V)2*rd,2 + (E/V)2*re,2

re,2 = (ra,2 - (D/V)2*rd,2) / (E/V)2= (4.25-0.7*2.5) / 0.3 = 8.33%

rwacc,2 = D/V*rd*(1-t) + re*E/V = 0.7*2.5*(1-0.25) + 8.33*0.3 = 3.81%

Alternatively, Ba is not affected.

Initially,

Ba = D/V * Bd + E/V * Be = 0.5*0.9 = 0.45

After change in capital structure, B a stays the same. Get new Be:

Be = (Ba - D/V * Bd) / (E/V) = (0.45-0.7*0.1) / 0.3 = 1.267

re,2 = rf + rpm*Be,2 = 2+1.267*5= 8.33% ----------- same as before.