Midterm Exam

ADM 3350

Corporate Finance
Summer 2022

Professor: Dr. Dev Gandhi Duration: 2 hours and 30 minutes

2:30PM – 5:00PM

Maximum Marks: 30

NAME: Lindsay Saint Pierre

STUDENT #: 8747369

Formulas: Attached

PLEASE NOTE: Show all relevant calculations to support your answers. Also remember that you are
ethically bound to do the exam entirely on your own. There should be no evidence to the contrary. You
must also finish the exam by 5:00PM to be able to upload it.

POINTS ALLOCATION

Problem 1: 6 points
Problem 2: 9 points
Problem 3: 6 points
Problem 4: 9 points

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 Use the following information to answer questions in Problem 1 (below) and Problem 2
(next page):

An unlevered (all-equity) firm has 500,000 common shares trading at $80 per share. With its
investment plan fixed, it is expected to generate a perpetual EBIT stream of $6 million per year.
The corporate tax rate is 40%. The firm is contemplating taking on debt by issuing a $20 million
face value perpetual bond carrying 5% coupon interest per year and using the proceeds to retire
some of its stock outstanding.

PROBLEM 1 (6 points: 2 points for each part)

a) What rate of return will shareholders require before the firm changes its capital structure?

Vu = 500 000 * 80 = 40 000 000

ROEU= (1-t)EBIT/VU
= (1-0.4)(6 000 000) / 40 000 000
= 0.09
= 9%
b) What will be the firm value after the firm changes its capital structure?

VL = VU+ tCD
= 40 000 000 + 0.4(20 000 000)
= 48 000 000

c) What will be the firm’s cost of equity after the firm changes its capital structure?

ROEL= (1-t)( EBIT-I)/EL

EL= VL – D
= 48 000 000 – 20 000 000
= 28 000 000

I = iD
= 0.05 * 20 000 000
= 1 000 000

ROEL = (1-0.4) ( 6 000 000 – 1 000 000) / 28 000 000

= 3 000 000/ 28 000 000
= 0.10714
= 10.71 %

2
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 PROBLEM 2 (9 points: 3 points for each part)

a) What will be the share price after the firm changes its capital structure?

Number of shares retired = 20 000 000/ 80

= 250 000 shares

The remaining shares = 500 000 - 250 000

= 250 000
Shares price = EL / 250 000
= 28 000 000/ 250 000
= 112

b) Suppose you are holding 100 shares bought at $80 per share just before the firm changes
its capital structure. How much capital gain tax will you pay by selling your 100 shares
just after the firm’s change its capital structure. Assume that the capital gain will be taxed
at half of the 40% corporate tax rate?

Capital gain tax = ( 112-80) * 100 * 0.2 = 640

c) What will be the firm’s WACC after the firm changes its capital structure?

WACC = (1-t)(EBIT) / VL
= (1-0.4) (6 000 000) / 48 000 000
= 0.075
=7.5 %

3
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 PROBLEM 3: (6 points: 2 points for each part)

An all-equity company has the following year-end market value balance sheet:

Excess cash $200,000 Debt $0

Other assets $800,000 Equity $1,000,000 (10,000 shares at $100 per share)

Total $1,000,000 Total $1,000,000

The firm is considering the following alternative uses of excess cash:

Alternative 1: Pay out cash dividends.

Alternative 2: Repurchase its own stock.

Suppose you own 600 shares of the firm’s common stock, and the company chooses Alternative
2 to repurchase its own stock:

a) Show with calculations that in absence of personal taxes and transaction costs, the share
price and your wealth will be the same before and after the repurchase.

Share price before repurchasing = 100

Number shares repurchased = 200 000/ 100 = 2 000

Number of remaining shares = 10 000 – 2 000= 8 000

Share price after repurchase = 800 000 / 8 000 = 100

That means the share price remains the same at 100 $

Wealth before repurchase = 600 * 100 = 60 000

Wealth after repurchase = 600 * 100 = 60 000

b) What will you do to create “home-made dividend” for yourself because the company did
not pay out dividends under Alternative 1?

The firm dividend paid out would have been 200 000 on 10 000 shares
DPS = 200 000/ 10 000 = 20 $
That means dividend per share would have been 20 $

Dividend on 600 shares = 20 * 600 = 12 000

4
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 Thus create 12 000 homemade dividends by selling: 12 000/100 = 120 shares

c) Suppose you had purchased the shares you own at $25 per share. Also suppose that the
dividends are taxed at 30% and the capital gains are taxed at half the regular income tax
rate of 40%. Suppose you create the home-made dividend in part b. How much difference
will there be in the tax you will pay, compared to the tax you would have paid if the
company had chosen Alternative 1?

Tax payable under alternative 1 of the dividend payment = 12 000* 0.3 =3 600

Capital gain tax with sales of 120 shares = 120* (100 -25) *0.5*0.4 = 1 800

Difference in tax = 3 600 -1 800 = 1 800

PROBLEM 4 (9 points: 3 points for each part)

You own 100 shares of stock of unlevered Maive Company which has 1,000 shares outstanding.
Maive plans to pay $4,600 dividend at the end of the current year (i.e., one year from today) and
a liquidating dividend of $10,580 at the end of 2 years from today. The required return on
Maive’s stock is 15 percent. Ignoring personal taxes and transaction costs:

a) What is the value of your shares of stock? Show calculations to support your answer.

4 600 10 580
Value of Maive Company =
(1+0.15)
+ (1+0.15)2
= 4000 + 8 000
= 12 000
Share price = 12 000/ 1000
= 12
Thus the value of the 100 shares = 100 * 12
= 1 200

b) Suppose shareholders want Maive to increase its $4,600 dividend payout at the end of the
current year to $6,486 and Maive finances this increase by issuing new stock at the end of
the current year worth the amount needed to increase the dividend. What will be the value
of your shares under this scenario? Show calculations to support your answer.

Increase in dividend = 6 486 -4 600 = 1886

End of year 2

5
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 1886*1.15 = 2 168.9
Thus at end year 2 = 10 580 – 2 168.9 = 8 411.1

6 486 8 411.1
Value of Maive company = +
1.15 1.152
=5 640 + 6360
= 12 000
Shares price = 12 000 / 1000
= 12 $
Thus, the share price remains the same at 12 $. That means the value of 100 shares will
also remain the same at 1 200 $

c) How many shares will be issued to the new stockholders at the end of the current year?
Show calculations.

Value of Maive 1 000 at the current year end

10 580/ 1.15 = 9 200

That means the shares price at the end of the year is

9 200/ 1000 = 9.2

Thus the number of shares issues for the new stock worth of 1 886

1 886/9.2 = 205 shares

6
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 FORMULAS

With only corporate tax rate t c

( 1−t c ) EBIT
1. V U=
ROEU

2. V L =V U +t c D

3. E L=V L −D

(1−t c ) EBIT
4. WACC=
VL

EL D
5. WACC= ( )
VL
ROE L +
VL ( )
( 1−t c ) i

(1−t c )( EBIT −I )
6. ROE L= Where I = Interest Payment (in dollars =iD)
EL

L U D U
7. ROE =ROE +
EL
( ROE −i)(1−t c ) (Where i is the interest rate)

7
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