Finance for Executives Managing for

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 Finance For Executives -5th Edition-Chapter 13

Answers to Review Problems

1. Earnings per share analysis.

a. The following tables show the calculations of Chloroline’s EPS and return on investment as a
function of the firm’s EBIT, without debt and with debt.

Current Capital Structure: No Debt and Two Million Shares Outstanding

Recession Expected Expansion

Earnings before interest and tax (EBIT) $5.0 million $15.0 million $20.0 million
Less interest expenses $0 $0 $0
Equals earnings before tax $5.0 million $15.0 million $20.0 million
Less tax (40 percent of earnings before tax) $2.0 million $6.0 million $8.0 million
Equals net earnings $3 million $9.0 million $12.0 million
Divided by the number of shares 2 million 2 million 2 million
Equals earnings per share (EPS) $1.5 $4.5 $6
Divided by share price $50 $50 $50
Equals return on investment 3.0% 9.0% 12.0%

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.

2. Firm value and capital structure in the absence of tax.

This statement is false. An increase in debt financing has two consequences: (1) an increase in risk
for both shareholders and debt holders and (2) an increase in the firm’s expected earnings before
interest. Each effect cancels each other, leaving the value of the firm unchanged. However, since
shareholders are taking more risk, the return expected from their equity investment in the firm will
rise to reflect the higher risk.

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. Number of shares outstanding 1 million

2. Share price $60
3. Market value of Alberton’s assets (line 1 × line 2) $60 million

Under the new capital structure

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:

1. Number of shares outstanding 700,000

2. Number of shares owned by Mr. Robert 98,000
3. Distributable earnings (see line 8 above) $2.2 million
4. Amount of dividend to be received by Mr. Robert (line 3  line 2)/line 1) $308,000
5. Amount of debt subscribed by Mr. Robert $2.52 million
6. Interest rate 10%
7. Amount of interest to be received by Mr. Robert (line 6  line 5) $252,000
8. Total amount of cash to be received by Mr. Robert (line 4 + line 7) $560,000

4. Cost of debt versus cost of equity.

The argument is irrelevant. Using more debt relative to equity makes the firm riskier for both
shareholders and bondholders, thus increasing the return expected by them from investing in the
firm. Both the cost of debt and the cost of equity increase with more debt financing, especially the
latter since shareholders are residual claimants of the firm’s cash flows.
 According to the capital asset pricing model, a higher debt-to-equity ratio increases the equity beta
coefficient, and as a result, the equity risk premium required by the equity holders (see equations
12.6 and 12.10).

5. Changes in capital structure and the cost of capital.

a. In the absence of debt, the cost of equity of Starline is equal to the return from its assets because
the shareholders are the only claimants to the cash flows generated by these assets. Thus,
Starline’s return on assets is 14%. This is also Starline’s WACC in the absence of debt. As the
debt-to-equity ratio goes up from zero to 100%, Starline’s shareholders will bear more and
more (financial) risk. Equation 13.7 shows how the cost of equity is related to the leverage
ratio:
D
k LE = rA + ( rA − k D ) (1 − TC )
E
where:
k EL = cost of equity
rA = return on assets = 14%
kD = cost of debt = 8%
Tc = corporate tax rate = 40%
D/E = debt-to-equity ratio
D
k LE = .14 + (.14 − .08) (1 − .40)
E
D
k LE = .14 + .036
E
From equation 13.8, we have:
E D
WACC = k LE + k D (1 − Tc )
E+D E+D
D
1
= k LE + k D (1 − Tc ) E
D D
1+ 1+
E E

D/E 0 25% 50% 75% 100%

kD 0.08 0.08 0.08 0.08 0.08

k EL 0.14 0.149 0.158 0.167 0.176
WACC 0.14 0.129 0.121 0.116 0.112
 b.

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.

7. The value of the interest tax shield.

a. The annual tax savings, or interest tax shield (ITS), is:
 ITS = Tax rate  Interest rate  Amount of debt
= .35  .08  $25,000,000 = $700,000
If the debt is permanent, the present value of the interest tax shield is equal to the present value
of a perpetual annuity of $700,000 at 8 percent:
ITS $700,000
PV(ITS)permanent = = = $8,750,000
Interest rate .08
Note that the value of the tax shield would represent 8.75 percent of the market value of the
firm, since the firm has currently no debt and its market value is $100,000,000.
If the debt matures in five years, the present value of the interest tax shield is equal to the present
value of a five-year annuity of $700,000 at 8 percent:
$700,000 $700,000 $700,000 $700,000 $700,000
PV(ITS)5 years = + + + + = $2,794,897
1 + .08 (1 + .08)2 (1 + .08)3 (1 + .08) 4 (1 + .08)5
b. If the interest rate increases immediately after the debt is issued:
$700,000
PV(ITS)permanent = = $7,777,778
.09

and
$700,000 $700,000 $700,000 $700,000 $700,000
(ITS)5 years = + + + + = $2,722,756
1 + .09 (1 + .09) 2 (1 + .09)3 (1 + .09) 4 (1 + .09)5

8. Industry influence on the capital structure.

The probability that an electric utility goes bankrupt is quite small because (1) it is usually a local
monopoly and (2) most of its valuable assets are tangible ones. It should exhibit the highest debt
ratio among the three firms. At the opposite, a biotechnology firm’s most valuable assets are
intangible and its operating margin is likely to be quite volatile. As a result it should have the
lowest debt ratio. An auto parts firm is more (less) likely to go bankrupt compared to an utility
(biotechnology) firm because it has relatively less (more) tangible assets and more (less) volatile
operating margins.

9. Board of directors and management.

It is in the interest of the managers to maintain a low debt-to-equity ratio when the board of directors
exercise little power on them. By keeping financial leverage low, they reduce the probability of the
firm to face financial distress and the probability to be personally affected by these costs, such as
more oversight by the financial markets, lower personal revenues, low morale among employees,
etc.
10. Agency costs.
Shareholders expropriate wealth from bondholders when they induce management to (1) make
investments which are riskier than anticipated by bondholders, (2) increase debt at a higher level
than anticipated by bondholders, and (3) increase dividends or repurchase shares beyond what is
anticipated by bondholders. Note that bondholders can reduce the wealth expropriation by imposing
strict covenants to the debt issue.
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