Chapter 17 - Does Debt Policy Matter?

CHAPTER 17

Does Debt Policy Matter?

The values shown in the solutions may be rounded for display purposes. However, the answers were
derived using a spreadsheet without any intermediate rounding.

Answers to Problem Sets

1. Note that the market value of Copperhead is far in excess of its book value.

Ownership percent = shares owned / total shares

Ownership percent = 50,000 / 8m
Ownership percent = .00625, or .625%

Borrow = ownership percent × firm’s debt reduction

Borrow = .625% × $1m
Borrow = $6,250

Ms. Kraft owns .625% of the firm, which proposes to increase common stock to
$17 million and cut short-term debt by $1 million. Ms. Kraft can offset the firm’s
change in capital structure by borrowing $6,250 and buying that much more
Copperhead stock.

Est. Time: 01 - 05

2. a. The two firms have equal value; let V represent the total value of the firm.
Rosencrantz could buy 1% of Company B’s equity and borrow an amount
equal to:
0.01  (DA - DB) = 0.002V
This investment requires a net cash outlay of (0.007V) and provides a net
cash return of:
(0.01  profits) – (0.003  rf  V)
where rf is the risk-free rate of interest on debt. Thus, the two investments
are identical.

b. Guildenstern could buy 2% of Company A’s equity and lend an amount

equal to:
0.02  (DA - DB) = 0.004V
This investment requires a net cash outlay of (0.018V) and provides a net
cash return of:

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Chapter 17 - Does Debt Policy Matter?

(0.02  profits) – (0.002  rf  V)

Thus the two investments are identical.

c. The expected dollar return to Rosencrantz’ original investment in A is:

(0.01  C) – (0.003  rf  VA)
where C is the expected profit (cash flow) generated by the firm’s assets.
Since the firms are the same except for capital structure, C must also be
the expected cash flow for Firm B. The dollar return to Rosencrantz’
alternative strategy is:
(0.01  C) – (0.003  rf  VB)
Also, the cost of the original strategy is (0.007VA) while the cost of the
alternative strategy is (0.007VB).
If VA is less than VB, then the original strategy of investing in Company A
would provide a larger dollar return at the same time that it would cost less
than the alternative. Thus, no rational investor would invest in Company B
if the value of Company A were less than that of Company B.

Est. Time: 06 - 10

3. a. Share price = $10; Shares outstanding = 750

Operating income ($) 500 1,000 1,500 2,000

Interest ($) 250 250 250 250
Equity earnings ($) 250 750 1,250 1,750
Earnings per share ($) .33 1.00 1.67 2.33
Return on shares (%) 3.33 10.00 16.67 23.33

b. New capital structure:

Debt = $2,500

Equity = $10,000 – 2,500

Equity = $7,500

D/E = .33

βA = βD(D / V) + βE(E / V)
.8 = .0($2,500 / $10,000) + βE($7,500 / $10,000)
βE = 1.07

Est. Time: 06 - 10

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Chapter 17 - Does Debt Policy Matter?

4. a. Current equity is $1,000,000 [$100 per share x 10,000 shares]. After the
$200,000 debt issue and stock buyback, there should be $800,000 left in
equity producing a debt-to-equity ratio of .25 [$200,000/$800,000].

b. Earnings after capital restructuring = $110,000 – ($200,000 x 0.10) =

$90,000

Shares outstanding after capital restructuring = 10,000 shares – ($200,000

/ $100 per share) = 8,000 shares outstanding

EPS after capital restructuring = $90,000 / 8,000 = $11.25

c. Earnings after capital restructuring = $110,000 – ($400,000 x 0.10) =

$70,000

Shares outstanding after capital restructuring = 10,000 shares – ($400,000

/ $100 per share) = 6,000 shares outstanding

EPS after capital restructuring = $70,000 / 6,000 = $11.67

Est. Time: 06 - 10

5. a. True

b. True (as long as the return earned by the company is greater than the
interest payment, earnings per share increase, but the P/E falls to reflect
the higher risk).

c. False (the cost of equity increases with the ratio D/E).

d. False (the formula rE = rA + (rA - rD) (D/E) does not require rD to be

constant).

e. False (debt amplifies variations in equity income).

f. False (value increases only if clientele is not satisfied).

Est. Time: 01 - 05

6. a. Under Proposition I, the firm’s cost of capital (rA) is not affected by the
choice of capital structure. The reason the quoted statement seems to be
true is that it does not account for the changing proportions of the firm
financed by debt and equity. As the debt-equity ratio increases, it is true

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Chapter 17 - Does Debt Policy Matter?

that both the cost of equity and the cost of debt increase, but a smaller
proportion of the firm is financed by equity. The overall effect is to leave
the firm’s cost of capital unchanged.

b. Moderate borrowing does not significantly affect the probability of financial

distress, but it does increase the variability (and market risk) borne by
stockholders. This additional risk must be offset by a higher average
return to stockholders.

c. If the opportunity were the firm’s only asset, this would be a good deal.
Stockholders would put up no money and, therefore, would have
nothing to lose. However, rational lenders will not advance 100% of
the asset’s value for an 8% promised return unless other assets are
put up as collateral.
Sometimes firms find it convenient to borrow all the cash required for a
particular investment. Such investments do not support all of the
additional debt; lenders are protected by the firm’s other assets too.
In any case, if firm value is independent of leverage, then any asset’s
contribution to firm value must be independent of how it is financed. Note
also that the statement ignores the effect on the stockholders of an
increase in financial leverage.

d. This is not an important reason for conservative debt levels. So long as

MM’s Proposition I holds, the company’s overall cost of capital is
unchanged despite increasing interest rates paid as the firm borrows
more. (However, the increasing interest rates may signal an increasing
probability of financial distress—and that can be important.)

Est. Time: 06 - 10

7. a. The market price of the stock is not affected by the announcement.

b. Shares repurchased = repurchase amount / share price

Shares repurchased = $160m / $10
Shares repurchased = 16 million

c. Market value = debt + equity

Market value = $160m + [(25m – 16m)  $10]
Market value = $250 million

The market value of the firm is unchanged.

d. Debt ratio = debt / (debt + equity)

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Chapter 17 - Does Debt Policy Matter?

Debt ratio = $160m / $250m

Debt ratio = .64

e. No one gains or loses.

Est. Time: 06 - 10

8. a. The market value of the firm’s equity increases by $30 million, the amount
of the decrease in the market value of the firm’s existing debt. Therefore,
the price of the stock increases to:

Stock price = equity market value / shares

Stock price = [(15m × $10) + $30m] / 15m
Stock price = $12

b. Shares repurchased = repurchase amount / stock price

Shares repurchased = $60m / $12
Shares repurchased = 5 million

c. Market value = debt + equity

Market value = ($70m + 60m) + [(15m – 5 m)  $12)
Market value = $250 million

The market value of the firm is unchanged.

d. Debt ratio = debt / (debt + equity)

Debt ratio = $130m / $250m
Debt ratio = .52

e. The investors in the existing debt lose $30 million while the shareholders
gain this $30 million. The value of each share increases by:

Stock price gain = total gain / shares

Stock price gain = $30m / 15m
Stock price gain = $2

Est. Time: 06 - 10

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Chapter 17 - Does Debt Policy Matter?

9. This is not a valid objection. MM’s Proposition II explicitly allows for the rates of
return for both debt and equity to increase as the proportion of debt in the capital
structure increases. The rate for debt increases because the debtholders are
taking on more of the risk of the firm; the rate for common stock increases
because of increasing financial leverage. See Figure 17.2 and the
accompanying discussion.

Est. Time: 01 - 05

10. When a firm issues debt, it shifts its cash flow into two streams. MM’s
Proposition I states that this does not affect firm value if the investor can
reconstitute a firm’s cash flow stream by creating personal leverage or by
undoing the effect of the firm’s leverage by investing in both debt and equity.
It is similar with Carruther’s cows. If the cream and skim milk go into the same
pail, the cows have no special value. (If an investor holds both the debt and
equity, the firm does not add value by splitting the cash flows into the two
streams.) In the same vein, the cows have no special value if a dairy can
costlessly split up whole milk into cream and skim milk. (Firm borrowing does not
add value if investors can borrow on their own account.) Carruther’s cows will
have extra value if consumers want cream and skim milk and if the dairy cannot
split up whole milk or if it is costly to do so.

Est. Time: 06 - 10

11. a. Given a 12.5 percent cost of equity before debt we find the expected
return on equity:

rA = rD(D / V) + rE(E / V)
.125 = .05(.50) + rE(.50)
rE = .20, or 20%

b. The overall cost of capital will remain unchanged at 12.5 percent.

c. Maintaining the perpetual stream of earnings and dividends, the E/P must
now be 20 percent, which implies a P/E ratio of 5.

d. Assuming MM are correct, the stock price remains at $50.

e. Since the debt is risk free, its beta is zero; the beta of the stock is found
as:

βA = βD(D / V) + βE(E / V)
1.0 = .0(.50) + βE(.50)

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Chapter 17 - Does Debt Policy Matter?

βE = 2.0

Est. Time: 06 - 10

12. a. Debt after capital restructuring = $1,000,000 + $250,000 = $1,250,000

b. Equity after capital restructuring = $1,000,000 – $250,000 = $750,000

$1,250,000 $750,000
c. 𝑊𝐴𝐶𝐶 = 5.5% × $2,000,000 + 10.83% × $2,000,000 = 7.5%

d. Assuming Buggins Inc. is expected to earn a level stream of earnings in

perpetuity, the initial level of earnings should equal $100,000 [$1,000,000
equity value x 10% required return].

The initial EBIT is $150,000 [$100,000 earnings+ $1,000,000 debt x 5%

rdebt]

The earnings after capital restructuring are $81,250 [$150,000 EBIT –

$1,250,000 debt x 5.5% rdebt]

$81,250 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠
( )
% 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝐸𝑃𝑆 = [ (𝑥 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑠ℎ𝑎𝑟𝑒𝑠)×0.75 ⁄ $100,000 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 ] − 1
( (𝑥 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑠ℎ𝑎𝑟𝑒𝑠) )

$81,250 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 (𝑥 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑠ℎ𝑎𝑟𝑒𝑠)

% 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝐸𝑃𝑆 = [(𝑥 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑠ℎ𝑎𝑟𝑒𝑠)×0.75 × $100,000 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 ] − 1

% 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝐸𝑃𝑆 = 8.33%

e. Earnings after the capital restructuring are $81,250, while the equity value
after restructuring is $750,000, resulting in a P-E ratio of 9.23.

Est. Time: 06 - 10

13. Assuming the company’s risk of debt is not affected and there are no
taxes, the expected return on assets will not change. The expected return on
assets is:

rA = rD(D / V) + rE(E / V)
rA =.08(30 / 80) + .16(50 / 80)
rA =.13, or 13%

Holding rA constant, the new return on equity will be:

rA = rD(D / V) + rE(E / V)

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Chapter 17 - Does Debt Policy Matter?

.13 =.08(20 / 80) + rE (60 / 80)

rE =.1467, or 14.67%

Est. Time: 01 - 05

14. a. Debt = $5,000

Equity = $10,000 – 5,000

Equity = $5,000

Total = $10,000

The return on assets will remain constant at 15 percent.

rA = rD(D / V) + rE(E / V)
.15 =.125(.50) + rE (.50)
rE =.1750, or 17.50%

b. The beta of the assets is unchanged; βA= .6.

βA = βD(D / V) + βE(E / V)
.6 = .50βD + .50βE

To solve for two unknowns, you need two formulas:

The second formula requires the risk-free rate, which is:

Risk-free rate = 12.5% – 2.5

Risk-free rate = 10%

We know the risk premium per unit of beta must be constant, therefore:

Risk premiumD / βD= Risk premiumE / βE

(.125 – .100) / βD = (.175 – .100) / βE
βE = 3βD

Substituting back into our original formula we have:

.6 = .50βD + .50(3βD)
βD = .3

Given the value of βD:

βE = 3βD
βE = 3(.3)

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Chapter 17 - Does Debt Policy Matter?

βE = .9

Est. Time: 01 - 05

15. The company cost of capital is:

rA = (0.8  0.12) + (0.2 0.06) = 0.108 = 10.8%
Under Proposition I, this is unaffected by capital structure changes. With the
bonds remaining at the 6% default–risk free rate, we have:

Debt-Equity rE rA
Ratio
0.00 0.108 0.108
0.10 0.113 0.108
0.50 0.132 0.108
1.00 0.156 0.108
2.00 0.204 0.108
3.00 0.252 0.108
See figure below:

Rates of Return

rE
.250

.200

.150

.108 rA

.060 rD

1 2 3 Debt / Equity

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Chapter 17 - Does Debt Policy Matter?

Est. Time: 06 - 10

16. a. As leverage is increased, the cost of equity capital rises. This is the same
as saying that, as leverage is increased, the ratio of the income after interest (which is
the cash flow stockholders are entitled to) to the value of equity increases. Thus, as
leverage increases, the ratio of the market value of the equity to income after interest
decreases.

b. (i) Assume MM are correct. The market value of the firm is determined
by the income of the firm, not how it is divided among the firm’s
security holders. Also, the firm’s income before interest is
independent of the firm’s financing. Thus, both the value of the firm
and the value of the firm’s income before interest remain constant as
leverage is increased. Hence, the ratio is a constant.
(ii) Assume the traditionalists are correct. The firm’s income before
interest is independent of leverage. As leverage increases, the firm’s
cost of capital first decreases and then increases; as a result, the
market value of the firm first increases and then decreases. Thus, the
ratio of the market value of the firm to firm income before interest first
increases and then decreases, as leverage increases.

Est. Time: 06 - 10

17. We begin with rE and the capital asset pricing model:

rE = rf + E(rm – rf)
rE = .10 + 1.5(.18 – .10)
rE = .2200, or 22.00%

Similarly for debt:

rD = rf + D(rm – rf)
.12 = .10 + D(.18 – .10)
D = .25

Also, we know that:

rA = rD(D / V) + rE(E / V)
rA = .12(.50) + .22(.50)
rE = .1700, or 17.00%

Lastly, solving for A:

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Chapter 17 - Does Debt Policy Matter?

βA = βD(D / V) + βE(E / V)
βA = .25(.50) + 1.5(.50)
βA = .88

Est. Time: 06 - 10

18. We know from Proposition I that the value of the firm will not change. Also,
because the expected operating income is unaffected by changes in
leverage, the firm’s overall cost of capital will not change. In other words, r A
remains equal to 17% and A remains equal to 0.875. However, risk and,
hence, the expected return for equity and for debt, will change. We know that
rD is 11%, so that, for debt:
rD = rf + D (rm – rf)
0.11 = 0.10 + D (0.18 – 0.10)
D = 0.125
For equity:
 D   E 
r =   r  +   r 
A
D + E D
 D+E E

0.17 = (0.3  0.11) + (0.7  rE)
rE = 0.196 = 19.6%
Also:
rE = rf + E (rm – rf)
0.196 = 0.10 + E (0.18 – 0.10)
E = 1.20

Est. Time: 11 - 15

19. Examples of such securities are given in the text and include unbundled stock
units, preferred equity redemption cumulative stock and floating-rate notes. Note
that, in order to succeed, such securities must both meet regulatory requirements
and appeal to an unsatisfied clientele.

Est. Time: 01 - 05

20. rE = rA + (rA – rD)(D/E)

rE = .14 + (.14 – .095) × (45 / 55)
rE = .1768, or 17.68%

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Chapter 17 - Does Debt Policy Matter?

After-tax WACC = rD(1 –Tc)(D/V) + rE(E/V)

After-tax WACC = .095 × (1 – .40) × .45 + .1768 × .55
After-tax WACC = .1229, or 12.29%

Est. Time: 01 - 05

21. Assuming that $200 million of long-term bonds have been issued:

a. D = $200 million

E = $55  10m
E = $550 million

V=D+E
V= $200m + 550m
V = $750 million

After-tax WACC = rD(1 – TC)(D / V) + rE(E / V)

After-tax WACC = .07(1 – .21)($200m / $750m) + .12($550m / $750m)
After-tax WACC = .1027, or 10.27%

b. The after-tax WACC would increase to the extent of the loss of the tax
deductibility of the interest on debt. Therefore, the after-tax WACC would
equal the opportunity cost of capital, computed from the WACC formula
without the tax-deductibility of interest:

After-tax WACC = rD(D / V) + rE(E / V)

After-tax WACC = .07($200m / $750m) + .12($550m / $750m)
After-tax WACC = .1067, or 10.67%

22. We make use of the basic relationship:

 D   E 
r =  r (1 − T )  +  rE  
A  D C V   V 

Since overall beta (A) is not affected by capital structure or taxes, then:
rA = rf + A (rm – rf) = 0.06 + (1.5 × 0.08) = 0.18

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Chapter 17 - Does Debt Policy Matter?

The following table shows the value of rE for various values of D/E (and the
corresponding values of D/V), derived from the above formula. The graph is on
the next page.
After-tax
D /E D /V rA rD rE
WACC
0.00 0.00 0.1800 0.0600 0.1800 0.1800
0.05 0.05 0.1800 0.0600 0.1860 0.1793
0.10 0.09 0.1800 0.0600 0.1920 0.1786
0.15 0.13 0.1800 0.0600 0.1980 0.1780
0.20 0.17 0.1800 0.0600 0.2040 0.1775
0.25 0.20 0.1800 0.0600 0.2100 0.1770
0.30 0.23 0.1800 0.0610 0.2157 0.1765
0.35 0.26 0.1800 0.0620 0.2213 0.1760
0.40 0.29 0.1800 0.0630 0.2268 0.1755
0.45 0.31 0.1800 0.0640 0.2322 0.1750
0.50 0.33 0.1800 0.0650 0.2375 0.1746
0.55 0.35 0.1800 0.0660 0.2427 0.1741
0.60 0.38 0.1800 0.0670 0.2478 0.1737
0.65 0.39 0.1800 0.0680 0.2528 0.1733
0.70 0.41 0.1800 0.0690 0.2577 0.1729
0.75 0.43 0.1800 0.0690 0.2633 0.1726
0.80 0.44 0.1800 0.0700 0.2680 0.1722
0.85 0.46 0.1800 0.0725 0.2714 0.1717
0.90 0.47 0.1800 0.0750 0.2745 0.1711
0.95 0.49 0.1800 0.0775 0.2774 0.1706
1.00 0.50 0.1800 0.0800 0.2800 0.1700

0.3000

0.2500

0.2000
RETURN

0.1500

0.1000

0.0500

0.0000
0.00
0.05
0.10
0.15
0.20
0.25
0.30
0.35
0.40
0.45
0.50
0.55
0.60
0.65
0.70
0.75
0.80
0.85
0.90
0.95
1.00

DEBT-EQUITY RATIO

rE After-tax WACC

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Chapter 17 - Does Debt Policy Matter?

Est. Time: 11 - 15

23. Assume the election is near so that we can safely ignore the time value of
money. Because one, and only one, of three events will occur, the guaranteed
payoff from holding all three tickets is $10. Thus, the three tickets, taken
together, could never sell for less than $10. This is true whether they are
bundled into one composite security or unbundled into three separate securities.
However, unbundled they may sell for more than $10. This will occur if the
separate tickets fill a need for some currently unsatisfied clientele. If this is
indeed the case, then Proposition I fails. The sum of the parts is worth more than
the whole.

Est. Time: 06 - 10

24. Some shoppers may want only the chicken drumstick. They could buy a whole
chicken, cut it up, and sell off the other parts in the supermarket parking lot. This
is costly. It is far more efficient for the store to cut up the chicken and sell the
pieces separately. But this also has some cost, hence the observation that
supermarkets charge more for chickens after they have been cut.
The same considerations affect financial products, but:
a. The proportionate costs to companies of repackaging the cash flow stream
are generally small.
b. Investors can also repackage cash flows cheaply for themselves. In fact,
specialist financial institutions can often do so more cheaply than the
companies can do it themselves.

Est. Time: 06 - 10

25. Firms that are able to identify an unsatisfied clientele and then design a financial
service or instrument that satisfies the demands of this clientele can, in violation
of MM’s capital-structure irrelevance theory, enhance firm value. However, if this
is done successfully by one financial innovator, others will follow, eventually
restoring the validity of the MM irrelevance theory.
If the financial innovation can be patented, the creator of the innovation can
restrict the use of the innovation by other financial managers and thereby
continue to use the innovation to create value. Consequently, MM’s capital-
structure irrelevance theory would potentially be violated during the life of the
patent.

Est. Time: 06 - 10

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