Departament d’Economia i Empresa 2023-2024

Universitat Pompeu Fabra

Financial Management II Group 101/201

Seminar 2 - Capital structure

1. Zapp corporation is a fully equity-financed startup in the technology sector, in a

country where there are no taxes and capital markets are frictionless. You are the
financial manager trying to estimate the cost of financing for several new projects.
You have downloaded the data for the following comparable companies, the market
risk premium, and the risk-free rate:

Market Value Market Value Equity

Company
of Equity of Debt Beta
Alas inc 900 180 1,8
Joyful Z 1.000 500 2,7

Risk-free rate 2,00%

Market Risk Premium 5,00%

a) Calculate the unlevered beta of each comparable company, assuming their debt
is risk-free.

b) Estimate the unlevered beta of your company (Zapp) based on the betas of these
comparables.

c) Under the option of full equity finance, what is your company’s cost of equity
and WACC?

d) Now the CEO asks you to evaluate the option of changing Zapp’s funding
structure to 50% debt and 50% equity finance. You estimate that the cost of
Zapp’s debt would be 1 percentage point above the risk-free rate. What would be
the cost of equity of the company under this scenario?

2. Now the government of the country introduces a 40% tax on corporate profits.
Assume that the risk of the company, its projects, and the unlevered return on Zapp’s
equity remain as in question 1.

a) What is the post-tax WACC of Zapp if it is fully equity financed?

b) What is the post-tax WACC if it is financed with 50% equity and 50% debt,
assuming the cost of debt and equity are the same as in question 1d)?
 c) Under option b), assuming that Zapp has $10 million of debt outstanding, what
is its annual debt tax shield?

d) Would the annual debt tax shield be lower or higher if Zapp’s debt was risk-free?

3. Boom inc is launching a new product. Depending on its success, the total value of
Boom next year can take one of the following three values: $160 million (probability
60%), $130 million (probability 30%), and $20 million (probability 10%). The risk
premium for all the investors is zero (that is, the risk is diversifiable). No payouts to
investors will be made by Boom during the year. The risk-free interest rate is 5% and
capital markets are perfect. Investors are risk-neutral, and there are no taxes or
bankruptcy costs.
a) What is the initial value of Boom’s equity without leverage?
Now suppose Boom has zero-coupon debt with a $100 million face value due next
year.
b) What is the initial value of Boom’s debt?
c) What is the initial value of Boom’s equity? What is Boom’s total value with
leverage? Can you compare the result with the answer to question (a)?
d) Would Boom’s total value in option c) be higher or lower if defaulting on its
debt incurred a bankruptcy cost?
[Hint: think about the difference between VU and VL in the presence of
bankruptcy / financial distress costs, e.g. in the formula from Chapter 2 slides]

4. Zeta, a company 100% owned by Mark Zetaberg, is designing a new wireless router.
If the research is successful, the technology can be sold for $30 million. If the
research is unsuccessful, it will be worth nothing. To fund the research, Zetaberg
needs to raise $9 million.

a) Investors are willing to provide Zetaberg with the capital in exchange for
30% of the unlevered equity in the firm. What is the total market value of Zeta
without leverage?

b) Suppose that instead of raising 100% of the funding from equity investors,
Zetaberg decides to borrow $5 million. According to Modigliani-Miller, what
fraction of Zeta’s equity will he need to sell to raise the capital he needs?

c) After the capital raising, what is the value of Mark Zetaberg’s share of
Zeta’s equity in cases (a) and (b)?

d) (for class discussion) Would your answer to b) be different in the presence

of corporate taxes? [Hint: think about the difference between VU and VL in the
presence of the tax shield, e.g. using the formula from Chapter 2 slides]
5. A glass manufacturer Glitter, Inc. has a loan of 1 million euros due at the end of the
year. Without any change, the market value of its assets will be 800 thousand euros
at that time. Therefore, the firm will default on its loan and go bankrupt.

a) A new strategy is possible which requires no upfront investment and has a 30%
chance of success. If the strategy is successful, the value of the firm’s assets
will be 1.2 million euros. If not, the value of the firm’s assets will be 200
thousand euros.

Should Glitter change its strategy? Consider the point of view of the company,
the equity holders, and the debt holders.

b) Would your answers change if the investment had a 70% chance of success?