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Finance For Executives Managing For Value Creation 5th Edition Hawawini Solutions Manual
Finance For Executives Managing For Value Creation 5th Edition Hawawini Solutions Manual
Finance For Executives Managing For Value Creation 5th Edition Hawawini Solutions Manual
Proposed Capital Structure: Borrow $50 million at 8 percent and use the cash to repurchase 1
million shares at $50 per share
Recession Expected Expansion
Earnings before interest and tax (EBIT) $5.0 million $15.0 million $20.0 million
Less interest expenses on debt ($4.0 million) ($4.0 million) ($4.0 million)
Equals earnings before tax $1.0 million $11.0 million $16.0 million
Less tax (40 percent of earnings before tax) $0.4 million $4.4 million $6.4 million
Equals net earnings $0.6 million $6.6 million $9.6 million
Divided by the number of shares 1 million 1 million 1 million
Equals earnings per share (EPS) $0.6 $6.6 $9.6
Divided by share price $50 $50 $50
Equals return on investment 1.2% 13.2% 19.2%
b. The analysis shows that a substitution of debt for equity will increase Chloroline’s EPS and
return on investment in the expected and expansion scenarios, but will decrease EPS and return
on investment in the recession scenario. These results, however, are insufficient to make a
recommendation on whether the firm should recapitalize for the following reasons:
1. They do not show the impact of the recapitalization on the market value of Chloroline and
its share price.
2. They depend upon the accounting conventions that are used to calculate EBIT.
3. They do not account for the financial distress costs that debt financing generates.
3. Homemade leverage.
a. Currently, Alberton does not have any debt outstanding and it does pay any tax. Therefore, its
earnings after tax are equal to its earnings before interest and tax, which is $4 million. Since
the payout ratio is 100 percent, the amount of dividends paid to Alberton’s shareholders is $4
million. As an owner of 140,000 shares out of 1 million shares outstanding, Mr. Robert receives
$560,000 (14 percent of $4 million) every year.
b. Under the proposed capital structure, the number of shares outstanding will be reduced since
the proceeds of the debt issue will be used to buy back shares.
Currently
1. Debt-to-assets ratio 30 %
2. Amount of debt issued (line 4 line 3) $18 million
3. Number of shares repurchased (line 5/line 2) 300,000
4. Number of shares outstanding (line 1 – line 6) 700,000
5. Earnings before interest and tax (EBIT) $4 million
6. Interest rate 10%
7. Interest charges (line 9 line 5) $1.8 million
8. Distributable earnings (line 8 – line 10) $2.2 million
9. Number of shares owned by Mr. Robert 140,000
10. Cash to be received by Mr. Robert (line 11 line 12)/line 7) $440,000
c. Mr. Robert will receive less cash under the new capital structure than under the current one
($440,000 versus $560,000). This is because the interest rate on the debt, 10 percent, is higher
than Alberton’s return on assets, 6.67 percent ($4 million of EBIT divided by $60 million of
assets).
Mr. Robert can keep receiving $560,000 from his investment in Alberton if he does the
following:
• Tender a percentage of its shares equal to the percentage of shares that Alberton will buy back,
that is 30 percent (line 6/line 1), or 42,000 shares (30 percent of 140,000 shares). Mr. Robert
will then have 98,000 shares of Alberton (140,000 shares less 42,000 shares) plus $2.52 million
in cash.
• Subscribe to Alberton’s debt issue up to $2.52 million. From then on, Mr. Robert will receive
dividends and interest payments from Alberton, for a total of $560,000 every year, the same
amount he gets under the current capital structure:
k LE
WACC
kd
Debt-to-equity ratio
c. According to the above analysis, you would be tempted to recommend that Starline increase its
indebtedness as much as possible because the higher the level of debt, the lower the weighted
average cost of capital and the higher the value of the firm. However, the analysis ignores the
impact of financial distress costs on the WACC and on the value of the firm when debt is
increased.
Conclusion: You should not recommend an increase in debt on the basis of this analysis alone.
6. The cost of equity, the weighted average cost of capital, and financial leverage.
a. From equation 13.2:
D
k LE = rA + ( rA − k D )
E
where:
k EL = cost of equity
rA = expected return on the firm’s assets
kD = cost of debt
D/E = debt-to-equity ratio
At the current target capital structure of 80 percent equity and 20 percent debt (D/E=.25):
k LE = 12% + (12% – 8%) .25 = 13%
Since the return on assets does not depend upon the way the assets are financed, the equation
is still applicable if the target capital structure changes to 50 percent equity, 50 percent debt
(D/E = 1). Then, we have:
k LE = 12% + (12% - 8%) 1 = 16%
Albarval’s return on assets accrues to both its shareholders and debt holders in proportion to
their respective investments in the firm. Since a firm’s weighted average cost of capital
(WACC) is equal to the sum of the shareholders’ and bondholders’ expected returns in
proportion to their respective investments in the firm, it must be equal to the expected return on
the firm’s assets. Thus, Albarval’s WACC is 12 percent. As the return on assets does not depend
upon the way the assets are financed, the change in the target capital structure to 50 percent
equity, 50 percent debt (D/E = 1) does not affect the firm’s WACC that will still be 12 percent
under the new capital structure. This can be checked easily by computing the Albarval’s WACC
under both target capital structures.
b. From equation 13.7:
D
k LE = rA + ( rA − k D )(1 − Tc )
E
where:
Tc = corporate tax rate
When the target debt-to-equity ratio is .25, the cost of equity is:
k LE = 12% + (12% – 8%) (1 – .40) .25 = 12.6%
And, from equation 13.8, the weighted average cost of capital is:
E D
WACC = k LE + k D (1 − Tc )
E+D D+E
= 12.6% × .80 + 8% × (1 – .40) × .20 = 11.04%
When the target debt ratio is 1:
k LE = 12% + (12% – 8%) (1 – .40) 1 = 14.4%
and
WACC = 14.4% .50 + 8% (1 – .40) .50 = 9.6%
Although the return on assets is still not affected by changes in the capital structure, the
weighted average cost of capital is because the interest payments are tax deductible. The 8
percent interest rate required by Albarval’s debt holders changes to 4.8 percent [8% (1 – .40)]
when the corporate tax rate is 40 percent. Albarval’s WACC decreases from 11.04 percent to
9.6 percent when the debt ratio increases from .25 to 1 because the extra return expected by the
shareholders from the interest tax shield and the lower after-tax cost of debt more than offset
the higher financial risk generated by a higher level of debt.
II.
(DE «LA MONJA ALFÉREZ», DE CARLOS COELLO).
APÉNDICES
Proposición de la Alcaldía para trasladar los restos de Pizarro.
«Considerando: Que es de dignidad nacional dar honrosa
sepultura á los restos del conquistador del Perú, que hoy se
encuentran en la bóveda de la Iglesia Catedral,
«Propone: Que se autorice á la Alcaldía para que solicite del Ilmo.
y Rmo. Sr. Arzobispo y del Cabildo metropolitano la licencia
correspondiente para colocar los restos del Capitán general D.
Francisco Pizarro en una de las capillas de la Iglesia Catedral,
quedando autorizada igualmente la Alcaldía para hacer construir
una urna donde reposen estos restos, hasta que la nación pueda
construir un monumento para tal objeto.
«Lima, Abril 30 de 1891.—Juan Revoredo.»
II
Discurso del Alcalde de Lima al entregar la urna que debía
guardar los despojos mortales de Pizarro.
«Excelentísimo Señor:
«Señor Ilustrísimo:
«Señores:
«Conmemoramos en este momento el aniversario del
fallecimiento del ilustre Capitán general D. Francisco Pizarro,
acaecido hace hoy trescientos cincuenta años.
«Nos encontramos en presencia de sus restos, de cuya
autenticidad no podemos dudar desde que la Historia así nos lo
demuestra y desde que las generaciones que se han venido
sucediendo nos los han ido haciendo conocer de padres á hijos
hasta llegar á nosotros.
«Don Francisco Pizarro fué el conquistador del Perú, el fundador
de esta capital, el que en sus propios hombros cargó el primer
madero que sirvió para la fabricación del templo en que nos
encontramos, y, lo que es más, fué el que nos legó la Religión que
profesamos, dándonos hasta su última hora pruebas del respeto y
de la veneración que tenía por ella; pues recordaréis que besando la
Cruz del Calvario, que con su propia sangre y puño había formado
para elevar sus preces al Todopoderoso, exhaló su último aliento.
Estamos obligados á creer, señores, que el alma del que así murió
tiene que estar gozando de las delicias del Paraíso.
«Toca á nosotros honrar sus inapreciables restos, que continuarán
bajo la custodia del Muy Ilustre Cabildo metropolitano.»
III