Corporate Finance
Questions and Practice problems_Chapter 16
Ch. 16 Summary
- The best capital structure maximizes the benefits to stockholders.
- MM Assumptions: 1) No taxes, individuals borrow at the same rate as firms, no
bankruptcy/financial crisis.
- Required return on equity = Rs = Ro + (B/S)(Ro - Rs)
- (Corporate taxes, but no bankruptcy) Vl = Vu + TcB
- (Corporate taxes, but no bankruptcy) Rs = Ro + (1 - Tc) x (Ro - Rb) x (B/S)
- Higher value = higher leverage
1/ Unlevered firm: all-equity, no debt
Levered firm: with debt
EPS (Earnings per share) = Net income / Number of shares outstanding
ROE (Return on equity) = Net income / Total equity
ROA (Return on asset) = Net income / Total assets
2/ Break-even point is the EBIT that makes EPS (current capital structure, no
debt) = EPS (proposed capital structure, with debt)
EBIT/number of shares outstanding under current CS
= (EBIT – Interest) / number of shares outstanding under proposed CS
EBIT = ? : this is the break-even EBIT
If we expect EBIT less than the break-even EBIT (bad time), should not use debt
(leverage).
If we expect EBIT greater than the break-even EBIT (good time), should use debt
(leverage).
3/ M&M proposition I is about firm value
M&M proposition II is about cost of capital (cost of levered equity RS and cost
of capital RWACC)
4/ Slide 17: Value of a levered firm (with taxes)
VL = VU + BTc
where: VU = EBIT(1-Tc) / R0
Proof:
With taxes, interest expense on debt is tax deductible. Therefore, firm value
increases when firm uses debt.
The tax saving is: BRBTc : interest tax shield
Assume perpetual cash flow. The present value of interest tax shield: BR BTc / RB =
BTc
Conclusion: With taxes, the value of a levered firm increases by the present value
of interest tax shield. This is the M&M proposition I (with taxes).
5/ WACC:
No taxes:
Cost of capital (WACC) in a levered firm:
where RS (cost of equity in a levered firm) is calculated using formula
in slide 14
Cost of capital (WACC) in an all-equity firm:
RWACC = R0
With taxes:
Cost of capital (WACC) in a levered firm:
where RS (cost of equity in a levered firm) is calculated using formula in
slide 17
Chapter 16:
Concept questions (page 519 textbook): 3, 4
3. MM Propositions
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.
4. MM Propositions
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, where payments to shareholders (dividends) are
not tax deductible.
Questions and Problems (page 520 textbook): 4, 5, 10, 11, 13, 14, 15
Link key các bài dạng tương tự: https://quizlet.com/898430769/chapter-16-capital-structure-
flash-cards/
4. Break-Even EBIT
Rolston Corporation is comparing 2 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?
Under Plan I: All-equity the unlevered company, net income = EBIT (since no corporate tax)
The EPS under this capitalization will be:
EPS = $750,000/265,000 shares
EPS = $2.83
Under Plan II: Levered the levered company, EBIT will be reduced by the interest payment.
The interest payment is the amount of debt times the interest rate, so:
Interest expense = $ 2,800,000*10% = $280,000
Net Income = EBIT- Interest Exp = $750,000 – 10%x($2,800,000)
NI = $470,000
And the EPS will be:
EPS = $470,000/185,000 shares
EPS = $2.54
Plan I have the higher EPS when EBIT is $750,000.
b. If EBIT is $1,500,000, which plan will result in the higher EPS?
Under Plan I: All-equity the unlevered company, net income = EBIT (since no corporate tax)
The EPS under this capitalization will be:
EPS = $1,500,000/265,000 shares
EPS = $5.66
Under Plan II: Levered the levered company, EBIT will be reduced by the interest payment.
The interest payment is the amount of debt times the interest rate, so:
Interest expense = $ 2,800,000*10% = $280,000
Net Income (= EBIT- Interest Exp) = $1,500,000 – 10% x ($2,800,000)
NI = $1,220,000
And the EPS will be:
EPS = $1,220,000/185,000 shares
EPS = $6.595
Plan II has the higher EPS when EBIT is $1,500,000.
c. What is the break-even EBIT?
To find the break-even EBIT for 2 different capital structures, we set the equations for EPS
equal to each plan and solve for EBIT.
The break-even EBIT is:
EPS (plan I) = EPS (plan II)
EBIT/265,000 = [EBIT – 10% ($2,800,000)]/185,000 EBIT= $927,500.
5. MM and Stock Value
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?
We can find the price per share by dividing the amount of debt used to repurchase shares by the
number of shares repurchased. Doing so, we find the share price is:
Share price = $2,800,000/ (265,000 – 185,000)
Share price = $35 per share
The value of the company under the all-equity plan is:
V = $35 x (265,000 shares)
V = $9,275,000
And the value of the company under the levered plan is:
V = $35 x (185,000 shares) + $2,800,000 debt
V = $9,275,000
10. MM
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?
With no taxes, the value of an unlevered firm is the EBIT divided by the unlevered cost of equity,
so: V = EBIT/WACC
$37,000,000 = EBIT/0.09
EBIT = 0.09x ($37,000,000)
EBIT = $3,330,000
11. MM and Taxes
In the previous question, suppose the corporate tax rate is 35 percent. What is EBIT in this
case? What is the WACC? Explain.
The current market value of the equity is $37 million
If there are corporate taxes, the value of an unlevered firm is:
VU = EBIT x (1 - TC)/RU
Using this relationship, we can find EBIT as:
$37,000,000 = EBITx (1 – 0.35)/0.09
EBIT = $ 5,123,077
The WACC remains at 9%. Due to taxes, EBIT for an all-equity firm would have to be higher for
the firm to still be worth $37 million.
13. Calculating WACC
Shadow Corp. has no debt but can borrow at 8%. The firm’s WACC is currently 11%, and the tax
rate is 35%.
WACC=11%=R0 =0.11
RD=8%=0.08
TC=35%=0.35
a. What is Shadow’s cost of equity?
For an all-equity financed company:
WACC = R0= RS = 0.11, or 11%%
b. If the firm converts to 25 percent debt, what will its cost of equity be?
D=25%=0.25 E = 0.75
To find the cost of equity for the company with leverage we need to use M&M
Proposition II with taxes, so:
RS = R0+ (R0- RD)x(D/E)x(1 - TC)
RS = 0.11 + (0.11 – 0.08)x(0.25/0.75)x(1 – 0.35)
RS = 0.1165 = 11.65%
c. If the firm converts to 50 percent debt, what will its cost of equity be?
D=50%=0.5 E = 0.5
Using M&M Proposition II with taxes again, we get:
RS = R0+ (R0- RD)x(D/E)x(1 - TC)
= RE = RU + (RU - RD)x(D/E)x(1 - TC)
RS = 0.11 + (0.11 – 0.08)x(0.50/0.50)(1 – 0.35)
RS = 0.1295 = 12.95%
d. What is Shadow’s WACC in part (b)? In part (c)?
The WACC with 25% debt is:
WACC = (E/V) RS + (D/V)RD(1 - TC)
WACC = 0.75x(0.1165) + 0.25x(0.08)x(1 – 0.35)
WACC = 0.100375 = 10.04%
And the WACC with 50% debt is:
WACC = (E/V) RS + (D/V)RD(1 - TC)
WACC = 0.5x(0.1295) + 0.5x(0.08)x(1 – 0.35)
WACC = 0.09075= 9.075%
14. MM and Taxes
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:
VU = EBIT(1 - TC)/R0
VU = $185,000x(1 – 0.35)/0.16
VU = $751,562.5
The value of the levered firm is:
VL = VU + Tax Corporate x (Debt)
VL = $751,562.5+ 0.35x ($135,000)
VL = $798,812.5
15. MM and Taxes
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?
RU=0.16
RD= 0.09
Debt=D=$135,000 E=VL-D= $798,812.5-$135,000
TC=0.35
We can find the cost of equity using M&M Proposition II with taxes. Doing so, we find:
RE = RU + (RU - RD) x (D/E) x (1 - TC)
=RS = R0+ (R0- RD)x(D/E)x(1 - TC)
RE = 0.16 + (0.16 – 0.09) x [(135,000/ (798,812.5- 135,000)] x (1 - 0.35)
RE = 0.16925 = 16.925%
Using this cost of equity, the WACC for the firm after recapitalization is:
WACC = RS x(E/V) + RD x (1 - TC) x (D/V)
WACC = 0.16925x[(798,812.5- 135,000)/ 798,812.5] + 0.09x (1 – 0.35) x (135,000/798,812.5)
WACC = 0.1505 = 15.05%
When there are corporate taxes, the overall cost of capital for the firm declines the more
highly leveraged is the firm's capital structure. This is M&M Proposition I with taxes.
