ANSWER TO POP

QUESTIONS
Chapter 16
 Pop Question 1
Recession Expected Expansion
Current
EBIT $1,000 $2,000$3,000
Assets $20,000

◦ Suppose that River Cruises had issued $10,000 of Debt 0

debt, using the proceeds to buy back stock. Equity $20,000
Debt/Equity ratio 0
◦ A. What would be the impact of a $1,000 change in
Interest rate n/a
EBIT on earnings per share?
(8% proposed)
Shares 400
◦ B. Show how a conservative investor could “undo” outstanding
the change in River Cruise’s capital structure to Share price 50
create the same ROE as unlevered firm.
Answer to A
Debt/Equity Ratio = 1 All Equity Debt/Equity Ratio = 2/3

EPS_Expected=($2,000-$10,000×8%)/200=$6 EPS_Expected=$5 EPS_Expected=$5.67

EPS_Recession=($1,000-$10,000×8%)/200=$1 EPS_Recession=$2.5 EPS_Recession=$1.5
EPS_Expansion=($3,000-$10,000×8%)/200= $11 EPS_Expansion=$7.5 EPS_Expansion=$9.83

◦ Number of shares
repurchased=$10,000/$50=200 Number of
shares outstanding=400–200= 200

The more debts borrowed by the firm, EPS became more sensitive to the change of EBIT. This shows that
financial risk of a firm increases as financial leverage of a firm increases.
Answer to B
An investor can undo the firm’s leverage by buying the firm’s debts and stocks at the same time. For example,
the investor has $2,000, she can spend $1,000 buying debts and $1,000 buying stocks. With $50 per share, the
investor can buy back 20 shares.

Expected – Debt/Equity = 1 Expected – All Equity

◦ Earnings from equity = 20 × $6 = $120 ◦ ROE of the unlevered firm = 10%

◦ Interest from debts = $1,000 × 8% = $80

◦ The investor’s net profits $120 + $80 = $200
◦ ROE = $200 / $2,000 = 10%
Answer to B (Cont’d)
Recession – Debt/Equity = 1 Recession – All Equity

◦ Earnings from equity = 20 × $1 = $20 ◦ ROE of the unlevered firm = 5%

◦ Interest from debts = $1,000 × 8% = $80
◦ The investor’s net profits $20 + $80 = $100
◦ ROE = $100 / $2,000 = 5%
Answer to B (Cont’d)
Expansion – Debt/Equity = 1 Expansion – All Equity

◦ Earnings from equity = 20 × $11 = $220 ◦ ROE of the unlevered firm = 15%
◦ Interest from debts = $1,000 × 8% = $80
◦ The investor’s net profits $220 + $80 = $300
◦ ROE = $300 / $2,000 = 15%
 Pop Question 2
◦ In the year ending January 2018, Blue Star Inc. paid out $1,326 million as debt
interest. How much more tax would Blue Star have paid if the firm had been
entirely equity-financed? What would be the present value of Blue Star’s
interest tax shield if the company planned to keep its borrowing permanently at
the 2018 level? Assume an interest rate of 8% and a corporate tax rate of 21%.

7
Answer
◦ Annual tax shield = $1,326 million × 21% = $278.46 million
◦ PV of the tax shield = $278.46 million / 8% = $3,480.75 million