FIN 401 Lecture 5: Capital Structure Part II

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20 Feb 2017

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Individual investors can borrow at the same rate/cost as firms do. There are no costs of financial distress. Consider two firms, identical in every way except that the capital structure of firm u is all-equity and. Firm l has a mixture of debt and equity. Both firms have an annual ebit of ,000 per year forever and both face a 40% tax rate. Annual interest expense = ,500 x 0. 08 = ,000. Annual tax shield = (d x rd) x tc. Annual tax shield = ,000 x 0. 40 = . Pv (tax shield) = (d x rd) x tc/rd. Proposition i: the value of a levered firm (l) is the value of an otherwise identical unlevered firm (u) plus pv of the interest tax shield. The value of a firm increases as the firm borrows more because of the interest tax shield. Waterdrop inc. expects an ebit of ,000 every year forever.

Related Questions

David Lyons, CEO of lyons Solar Technologies, is concerned about his firm's level of debt financing. The company uses short term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other solar technology companies average about 30% debt, and Mr, Lyons wonders why they use so much more debt and how it affects stock prices. To gain some insights into matter, he poses the following question to you his recently hired assistant. Please answer the following question in your own words. Assume that firms U and L are in the same risk class and that both have EBIT=$500,000. FIrms U uses no debt financing and its cost of equity is rsu=14%. Firm L has $1 million of debt outstanding at a cost of Rd=8% There are no taxes Assume that the MM assumptions hold.

Please answer the following questions

Now assume that Firms L and U are both subject to a 40% corporate tax rate. Using the data given in Part b, repeat the analysis called for in b(1) and b (2) using assumptions from the MM model with taxes.

ceruleansnake410

QUESTION 1

BMC Inc. currently has $1,000,000 of 8% coupon bonds and 40,000 common shares outstanding. The tax rate is 40%. The firm is considering a large investment of $1,500,000 in a new project. The following options are feasible for raising this capital: ï· Option 1: Sell $1,500,000 worth of common stock at $50 per share. ï· Option 2: Issue $1,000,000 worth of 6% coupon bonds with a 20-year maturity, in addition to $500,000 worth of common stock at $50 per share.

a) Calculate the EBIT indifference point for the 2 options.

b) What is the EPS at the EBIT indifference point? At EBIT levels above the EBIT indifference point, which plan is better?

QUESTION 2

B&B Inc. has a book value of debt of $500,000. The market value of debt is $550,000. Its pre-tax cost of debt is 10%, and its beta is equal to 2. The tax rate is 40%. The firm has an annual EBIT of $200,000. In the market, you observe that T-bills are being sold to yield 1%, and the S&P/TSX Composite Index is expected to yield 6%.

What is B&Bâs weighted average cost of capital? Assume there is no cost of financial distress.

QUESTION 3

An unlevered firm, CEA Inc., has 160,000 common shares issued and outstanding. It has a perpetual constant EBIT of $800,000 and an unlevered beta of 1.5. The firm has corporate tax rate of 40%. The market risk premium is 8% and the risk- free rate is 3%. Assume a world of taxes and costs of financial distress.

a) Calculate the value of the firm.

b) Calculate the WACC for the firm.

c) What is the value of a share in the company and what is the EPS?

d) If the firm issues $1,000,000 of bonds with a coupon rate of 10%, and now the beta of the levered firm is 1.85, what is the value of the firm?

e) What is the WACC for the firm with its new capital structure?

Intermediate Financial Management 11th Edition

Chapter 15: Capital Structure Decisions Part 1 Mini Case

Assume you have just been hired as a business manager of PizzaPalace, a regional pizze restaurant chain. The company EBIT was $50 million last year and is not expected to grow. The firm is currently financed with all equity, and it has 10 million shares outstanding. When you took your corporate finance course, your instructor stated that most firms' owners would be financially better off if the firms used some debt. When you suggested this to your new boss, he encouraged you to pursue the idea. As a first step, assume that you obtained from the firm's investment banker the following estimated costs of debt for the firm at different capital structures:

PERCENT FINANCED WITH DEBT, Wd	rd
0%	-
20	8.0%
30	8.5
40	10.0
50	12.0

If the company were to recapitalize, then debt would be issued and the funds received would be used to repurchase stock. PizzaPalace is in the 40% state-plus-federal corprate tax bracket, its beta is 1.0, the risk free rate is 6%, and the market risk premium is 6%.

Please answer All Parts:

Part A: Provide a brief overview of capital structure effects. Be sure to identify the ways in which capital structure can affect the WACC and free cash flows.

Part B: 1) What is business risk? What factors influence a firm's business risk? 2) What is operating leverage, and how does it affect a firm's business risk? Show the operating breakeven point if a company has fixed costs of $200, a sales price of $15, and variable costs of $10.

Part C: Now, to develop an example that can be presented to PizzaPalace's management to illustrate the effects of financial leverage, consider two hypothetical firms: Firm U, which uses no debt financing, and Firm L, which uses $10,000 of 12% debt. Both firms have $20,000 in assets, a 40% tax rate, and an expected EBIT of $3,000. 1) Construct partial income statements, which start with EBIT, for the two firms. 2) Now calculate ROE for both firms. 3) What does this example illustrate about the impact of financial leverage on ROE?

Part D: Explain the difference between financial risk and business risk.

Part E: What happens to ROE for Firms U and L if EBIT falls to $2,000? What does this imply about the impact of leverage on risk and return?

Part F: What does capital structure theory attempt to do? What lessons can be learned from capital structure theory? Be sure to address the MM models.

Part G: What does the empirical evidence say about capital structure theory? What are the implications for managers?

Part H: With the preceding points in mind, now consider the optimal capital structure for PizzaPalace. 1) For each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC. 2) Now calculate the corporate value for each capital structure.

Part I: Describe the recapitalization process and apply it to PizzaPalace. Calculate the resulting value of the debt that will be issued, the resulting market value of equity, the price per share, the number of shares repurchased, and the remaining shares. Considering only the capital structures under analysis, what is PizzaPalace's optimal capital structure?

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FIN 401 Lecture 5: Capital Structure Part II

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