Corporate Finance

Questions and Practice problems_Chapter 16

Chapter 16:
Concept questions (page 519 textbook): 3, 4
Questions and Problems (page 520 textbook): 4, 5, 10, 11, 13, 14, 15

Concept question 2: In a world with no taxes, no transaction costs, and no costs of financial
distress, is the following statement true, false, or uncertain? If a firm issues equity to
repurchase some of its debt, the price per share of the firm’s stock will rise because the
shares are less risky. Explain.
=> False. The reduction in leverage will decrease risk and decrease the expected return.

Concept question 3: In a world with no taxes, no transaction costs, and no costs of financial
distress, is the following statement true, false, or uncertain? Moderate borrowing will not
increase the required return on a firm’s equity. Explain.
 False. Modigliani-Miller Proposition II (No Taxes) states that the required return on a
firm’s equity is positively related to the firm’s debt-equity ratio [RS = R0 + (B/S)(R0 –
RB)]. Therefore, any increase in the amount of debt in a firm’s capital structure will
increase the required return on the firm’s equity.

Concept question 4: What is the quirk in the tax code that makes a levered firm more
valuable than an otherwise identical unlevered firm?
 Interest payments are tax deductible, whereas payments to shareholders (dividends) are
not tax deductible.

Problems

Problem 1: Money, Inc., has no debt outstanding and a total market value of $275,000.
Earnings before interest and taxes, EBIT, are projected to be $21,000 if economic
conditions are normal. If there is strong expansion in the economy, then EBIT will be 25
percent higher. If there is a recession, then EBIT will be 40 percent lower. Money is
considering a $99,000 debt issue with an interest rate of 8 percent. The proceeds will be
used to repurchase shares of stock. There are currently 5,000 shares outstanding. Ignore
taxes for this problem.
a. Calculate earnings per share, EPS, under each of the three economic scenarios before
any debt is issued. Also calculate the percentage changes in EPS when the economy
expands or enters a recession.
b. Repeat part (a) assuming that Money goes through with recapitalization. What do you
observe?
=> a. Earning per share = EBIT/shares outstanding
- Normal = 21,000/5,000 = $4.2
- Strong expansion = 21,000(1+0.25)/ 5,000 = $5.25
- Recession = 21,000(1-0.4)/5,000 = $2.52
Percentage change in EPS
- Normal to expand = (5.25-4.2)/4.2 = 25%
 - Normal to recession = (2.52-4.2)/4.2 = -40%

b. Value per share = $275,000/5000 = $55 per share

If $99,000 worth of debt is raised to retire stock, then there will be buying back of $99,000/$55 =
1,800 shares. So, after recapitalization there will be 5000 - 1800 = 3200 shares outstanding

We wil reduce EBIT by the interest expense of $99,000*8% = $7,920, New EBIT:

EBIT Strong Normal Recession

EBIT $26,250 $21,000 $12,600

Less Interest $7920 $7920 $7920

New EBIT $18,330 $13,080 $4,680

Earning per share = EBIT/No. of shares

Normal = $13,080 /3200 =$4.0875

Strong = $18,330/3200 =$5.73

Recession = $4,680/3200 =$1.4625

Percentage changes in EPS:

Normal to strong = ($5.73-$4.0875)/$4.0875=40.18%

Normal to recession = ($1.4625-$4.0875)/$4.0875= -64.22%

Problem 4: Rolston Corporation is comparing two different capital structures, an all-equity

plan (Plan I) and a levered plan (Plan II). Under Plan I, Rolston would have 265,000 shares
of stock outstanding. Under Plan II, there would be 185,000 shares of stock outstanding
and $2.8 million in debt outstanding. The interest rate on the debt is 10 percent and there
are no taxes.
a. If EBIT is $750,000, which plan will result in the higher EPS?
b. If EBIT is $1,500,000, which plan will result in the higher EPS?
c. What is the break-even EBIT?

=> a.
Plan I Plan II
Stock outstanding 265,000 shares 185,000 shares
Debt outstanding 2,800,000
Interest on Debt outstanding 10%*2,800,000=280,000
 EPS = EBIT 750,000−280,000
=
EBIT 750,000 stock outstanding 185,000
=
stock outstanding 265,000 = $2.54
= $2.83 >

 Plan I has the higher EPS when EBIT is $750,000.

b.
Plan I Plan II
Stock outstanding 265,000 shares 185,000 shares
Debt outstanding $2,800,000
Interest on Debt outstanding 10%*2,800,000=280,000
EPS = EBIT 1,500,000−280,000
=
EBIT 1,500,000 stock outstanding 185,000
=
stock outstanding 265,000 = $6.59
= $5.66 <

 Plan II has the higher EPS when EBIT is $1,500,000.

EBIT EBIT −280,000

c. = =¿ EBIT =927,500
265,000 185,000

Problem 5: In Problem 4, use MM Proposition I to find the price per share of equity under
each of the two proposed plans. What is the value of the firm?

2,800,000
=> Share price = =$ 35 / per share
265,000−185,000
The value of the company under the all-equity plan is:
V= $35 * 265,000 = $9,275,000
The value of the company under the levered plan is:
V = $35 * 185,000 + $2,800,000 debt = $9,275,000

Problem 8: Star, Inc., a prominent consumer products firm, is debating whether or not to convert
its all-equity capital structure to one that is 35 percent debt. Currently there are 6,000 shares
outstanding and the price per share is $58. EBIT is expected to remain at $33,000 per year
forever. The interest rate on new debt is 8 percent, and there are no taxes.
a. Ms. Brown, a shareholder of the firm, owns 100 shares of stock. What is her cash flow under
the current capital structure, assuming the firm has a dividend payout rate of 100 percent?
b. What will Ms. Brown’s cash flow be under the proposed capital structure of the firm? Assume
that she keeps all 100 of her shares.
c. Suppose Star does convert, but Ms. Brown prefers the current all-equity capital structure.
Show how she could unlever her shares of stock to recreate the original capital structure.
d. Using your answer to part (c), explain why Star’s choice of capital structure is irrelevant.

=> Current Capital Struction – 100% equity

Debt – Equity Ratio = Debt/Equity = 0
Total firm value = 6000*$58 = $348,000
a) Since, current their is no taxes and no interest payment, EBIT will be the earnings available to
shareholders'.
EPS = Earnings available to equity shareholders' / no. of shares = $33,000 / 6000 shares = $5.5/
per share
Cash flow for Ms. Brown = $5.5 per share x 100% x 100 shares = $550
b) To change the capital structure, the firm will:
1. Borrow 35% of the total firm value = $348,000 x 35% = $121,800
2. Repurchase shares worth $121,800 at the current market price = $121,800 / $58 per share =
2100 shares
No. shares after recapitalisation = 6000 - 2100 = 3900
New Earnings available to equity shareholders = EBIT - Interest = $33,000 - 8% x $121,800 =
$23,256
New EPS = $23,256 / 3900 = $5.96
New Cash flow for Ms. Brown = $5.96 x 100 = $596
c) To unlever her shares, she will Lend 35% of her wealth. So, when firm repurchases /
buybacks, she sells 35% of her shares and lends 8%
Amount received when shares sold $58 = 100 x 35% x $58= $2,030
Now, she will lend this amount and earn interest on the same -
Interest Income = $2,030 x 8% = $162.4
Cash Flow = Dividend on shares held + interest Income
= 65 x $5.96 + $162.4 = $549.8
d) The question shows no matter how a firm alters its capital structure, shareholders can
homemade / re-create the capital structure that they desire. Since they can create any capital
structure they like, they won’t pay for a premium for a particular structure. Therefore, capital
structure is irrelevant.f

Problem 10: Nina Corp. uses no debt. The weighted average cost of capital is 9 percent. If
the current market value of the equity is $37 million and there are no taxes, what is EBIT?

=> EBIT=Cost of Capital * Value of Equity =9%* 37 million = 3,300,000

Problem 11: In the previous question, suppose the corporate tax rate is 35 percent. What is
EBIT in this case? What is the WACC? Explain.
 9 %∗37 million
=> EBIT = =5,123,076.92
( 1−35 % )
The WACC remains at 9 percent as there is no debt. Due to taxes, EBIT for an all-equity firm
would have to be higher for the firm to still be worth $37 million.

Problem 13: Shadow Corp. has no debt but can borrow at 8 percent. The firm’s WACC is
currently 11 percent, and the tax rate is 35 percent.
a. What is Shadow’s cost of equity?
b. If the firm converts to 25 percent debt, what will its cost of equity be?
c. If the firm converts to 50 percent debt, what will its cost of equity be?
d. What is Shadow’s WACC in part (b)? In part (c)?

=> a. For an all-equity financed company: WACC = R0 = RS = .11 or 11%

Debt
b. Cost of equity = WACC + (WACC – Cost of debt) x ( )x (1 – tax rate)
Equity
= 11% + (11% - 8%) x ( 1−25
25 %
%)
x ( 1−35 % )
= 11.65%
Debt
c. Cost of equity = WACC + (WACC – Cost of debt) x ( )x (1 – tax rate)
Equity
= 11% + (11% - 8%) x ( 1−50
50 %
%)
x ( 1−35 % )
= 12.95%
d. WACC in part b = (Percentage of equity financing × Cost of equity) + | (Percentage of
debt financing × Cost of debt) x (1- Tax rate)
= ( (1-25%) x 11.65%) + (25% x 8%) x (1-35%) = 10.0375%
WACC in part c = ( (1-50%) x 12.95%) + (50% x 8%) x (1-35%) = 9.08%

Problem 14: Bruce & Co. expects its EBIT to be $185,000 every year forever. The firm can
borrow at 9 percent. Bruce currently has no debt, and its cost of equity is 16 percent. If the
tax rate is 35 percent, what is the value of the firm? What will the value be if Bruce
borrows $135,000 and uses the proceeds to repurchase shares?

=> The value of the unlevered firm is:

EBIT (1−tax) 185,000(1−35 %)
Vu = = = $751,562.5
cost of equity 16 %
The value of the levered firm is:
VL= Value of unlevered firm + Tax rate × debt amount
= $751,562.5 +0.35 *($135,000)
= $798,812.5

Problem 15: In Problem 14, what is the cost of equity after recapitalization? What is the
WACC? What are the implications for the firm’s capital structure decision?

=> The market value of equity is:

V=B + S => S = V-B = 798,812.5 – 135,000 = $663,812.5
Using the M&M proposition II with taxes, the cost of equity is:
B 135,000
Rs = Ro + x (Ro-RB)x(1-Tax rate) = 0.16 + x (0.16-0.09)x(1-0.35) = 16.93%
S 663,812.5
Using this cost of equity, the WACC for the firm after recapitalization is:
S B 663,812.5 135,000
WACC = ∗R s + ∗R b∗( 1−tax rate )= ∗16.93 % + ∗0.09 ( 1−0.35 )
V V 798,812.5 798,812.5
= 15.05%
-> When there are corporate taxes, the overall cost of capital for the firm declines the more
highly leveraged is the firm’m capital structure. This is M&M proposition II with taxes.