Capital Structure

Q1:

ABC Inc., is an unlevered firm with expected annual earnings before taxes (EBIT) of $30 million
in perpetuity. The required return on the firm’s unlevered equity is 15%, and the firm distributes
all of its earnings as dividends at the end of each year. ABC has 1 million shares of common
stock outstanding.

The firm is planning a recapitalization under which it will issue $50 million of perpetual debt and
use the proceeds to buy back shares. The annual cost of debt is 10%. Assume that there is no
issuing cost and that the firm is operating under perfect capital markets.

Part 1: If there is no corporate tax:

a. Calculate the value of ABC before the recapitalization plan is announced. What is the price
per share?
b. Calculate the value of ABC after the recapitalization plan is announced. What is the price
per share right after the announcement?
c. How many shares will be repurchased (assume shares are perfectly divisible, i.e. can take
fractional shares)?

Part 2: Company is subjected to 35% corporate tax.

d. Redo the a, b, c

Q2:

M&M theory. Star, Inc., a prominent consumer products firm, is debating whether or not to
convert its all-equity capital structure to one that is 50 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 1,000 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 1,000 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.

Capital Budgeting
Q1:

Existing machine was purchased 2 years ago at a cost of $3,200. It is being depreciated straight
line over its 8-year life. It can be sold now for $3,000 or used for 6 more years at which time it
will be sold for an estimated $500. It provides revenue of $5,000 annually and cash operating
costs of $2,000 annually.

A replacement machine can be purchased now for $7,800. It would be used for 6 years, and
depreciated straight line. It will result in additional sales revenue of $1,500 annually, but
because of its increased efficiency it would reduce cash operating costs by $600 per year. The
new machine would require additional inventories of $700, accounts receivable would increase
by $600 and trade payable increase by $300 at the initial. Its expected salvage value in 6 years is
$2,000.

The tax rate is 40% and the required rate of return is 13%. Should the old machine be replaced?

a. Calculate the incremental cash flow at time 0.

b. Calculate the incremental annual operating cash flows that result from the new machine.
c. Calculate the incremental terminal cash flow.
d. Show the incremental CFs.

Year Cash Flow

0 ________
1 ________
2 ________
3 ________
4 ________
………

e. Calculate the NPV for this project.

Q2:
Your firm is considering a project with a five-year life and an initial cost of $120,000. The
discount rate for the project is 12%. The firm expects to sell 2,100 units a year. The cash flow per
unit is $20. The firm will have the option to abandon this project after three years at which time
it expects it could sell the project for $50,000. You are interested in knowing how the project will
perform if the sales forecasts for years four and five of the project are revised such that there is a
50% chance that the sales will be either 1,400 or 2,500 units a year. What is the net present value
of this project given your sales forecasts?

Merger and Acquisition

Q1:

Consider the following premerger information about a bidding firm (firm B) and a target firm
(firm T). Assume that both firms have no debt outstanding.
Firm B Firm T
Share outstanding 2,900 1,400
Price per share $39 $26
Firm B has estimated that the value of the synergistic benefits from acquiring firm T is $550 per
year indefinitely. The appropriate discount rate for the incremental cash flows is 10 percent.

a. If firm T is willing to be acquired for $29 per share in cash. What is the merger premium,
what is the NPV of the firm B?
b. What will the price per share of the merged firm be assuming the condition in (a)?
c. Suppose firm T is agreeable to a merger by an exchange of stock. If B offers three of its
shares for every five of T’s shares, what will the price per share of the merged firm be?
What is the merger premium, what is the NPV of the firm B?
d. Should the shareholders of firm T choose the cash offer or the stock offer? At what
exchange ratio of B shares to T shares would the shareholders in T be indifferent between
the two offers?
Q2:

Your company has earnings per share of $4. It has 1.6 million shares outstanding, each of which
has a price of $56. You are thinking of buying TargetCo, which has earnings per share of $1, 1.3
million shares outstanding, and a price per share of $24. You will pay for TargetCo by issuing
new shares. There are no expected synergies from the transaction.
a. If you pay no premium to buy TargetCo, what will your earnings per share be after the
merger? Given that the EPS of the combined firm is equal to sum of EPS of acquirer and
acquiring firms.
b. Suppose you offer an exchange ratio such that, the offer represents a 20% premium to buy
TargetCo. What will your earnings per share be after the merger?
c. What will your price-earnings ratio be after the merger (if you pay no premium)? How
does this compare to your and TargetCo’s P/E ratio before the merger.

Problem 3. Dividend Policy (20 marks)

a. A U.S. company’s annual earnings are $300, and the corporate tax rate is 35%. Assume that
the company pays out 100% of its earnings as dividends. Calculate the effective tax rate
on a dollar of corporate earnings paid out as dividends assuming a 15% tax rate on
dividend income. (5 marks)
b. Suppose that the Larson Company has $1,000 in earnings and $900 in planned capital
spending (representing positive NPV projects). Larson has a target debt-to-equity ratio
of 0.5. Calculate the company’s dividend under a residual dividend policy. (5 marks)
c. JetFun Inc. has 10 million shares outstanding and has just reported net income of $50
million. Because the company has $100 million of excess cash currently earning no
return, JetFun’s directors are considering repurchasing shares at a premium of 25% over
the current market price of $40. Calculate the effect of repurchase on EPS when the
repurchase is financed using the existing surplus cash. (5 marks)
d. It is sometimes suggested that firms should follow a “residual” dividend policy. With such
a policy, the main idea is that a firm should focus on meeting its investment needs and
maintaining its desired debt−equity ratio. Having done so, a firm pays out any leftover,
 or residual, income as dividends. What do you think would be the chief drawback to a
residual dividend policy? (5 marks)
Leasing

Quartz Corporation is a relatively new firm. Quartz has experienced enough losses during its
early years to provide it with at least eight years of tax loss carryforwards. Thus, Quartz’s
effective tax rate is zero. Quartz plans to lease equipment from New Leasing Company. The term
of the lease is five years. The purchase cost of the equipment is $840,000. New Leasing
Company is in the 35 percent tax bracket. There are no transaction costs to the lease. Each firm
can borrow at 10 percent. Assume that: leasing payments are paid at the beginning of the
period but the tax benefits are received at the end of the period.
a. What is Quartz’s reservation price?
b. What is New Leasing Company’s reservation price?
c. Explain why these reservation prices determine the negotiating range of the lease.

Short term Finance

Anne Teak, the financial manager of a furniture manufacturer, is considering operating a lockbox
system. She forecasts that 300 payments a day will be made to lockboxes, with an average
payment size of $1,600. The bank’s charge for operating the lockboxes is either $.40 a check or
compensating balances of $800,000.
a. If the interest rate is 9%, which method of payment is cheaper? (use 360-day basis)

b. What reduction in the time to collect and process each check is needed to justify use of the
lockbox system?
Capital structure
Question 1:

Part 1:If there is no

corporate tax

a, Y EBIT =
x (1 -
Tc)
$30,000,000 x (1-0%):$200,000,000
=

Ro
15%

Yu $200,000,000
PPS =
I $200
=

Number shares
outstanding 1,000,000
of

b. Notaces Vi (n $200,000,000
-
=
=

Un $200,000,000
PPS the announcement
rightafter is: $200
=
->
-

Number
of
shares
outstanding 1,000,000

Number share
c.
of repurchased is:
ext $50,000,000 250,000 shares
=

$200

Part 2:
Company subjected is to 35%
corporate
41-35%)
trices

G, Yu EBIT x
=
(1 -
Tc
$50,000,000
=
x

$130,000,000
=

15%
Ro

PPS =
Vu $130,000,000
=
=

$138
Number shares
outstanding 1,000,000
of
b, Y Yn =

Te xB $130,000,000 35%x
+
=
+

$50,000,000 =
$147,500,000

Wh
pps
rightafter the announcement is:
Number
of
shares
=

outstanding
$147,500,088 $147. =

c Number shares repurchased 19:

$50,000,000
Debt 384,675 shares
= -

PPS

Question 2:

current capital structure: structure.

as
all-equitycapital
=> NI EBIT $33,000= =

$33,000
=

EBIT
EPS= shares outstanding
=

6,000
$5.5
=

of in

Ms. Brown owns 1000 shares - the cash

flow under current
capital
structure is

1000x$5,5 $5,500 =

b, structure:50 percentdebt,
proposed capital 50 percentequity:
50% Number
repurchased Debt ofshares
outstanding xP4S
Number shares
x
50%x6000 3000 =

of
=
=
=

PPS
 Number shares 6000 3,000 3,000 shares
of remaining
=

=
=

NI EBIT = -
Interest -
Taxes $33,000 =

8%x(($50 6,000; x50%)

x
-

0 $19,880
=

EPS NI
=> = $19,080
=

$6.36
=

Number shares 3,000

of remaining
Ms. Brown owns 1088 shares her
-

cashylows under
proposed capital structureis:

1000 86.36
x $6,360
=

>Ms. Brown can unlevered her shares

of
stock
by selling 50%
of
her shares,
taking
money
and lending that
money
For star, Inc at 8% atP $58 per share
=

-> the interestcash flow is:8% x($58 x 50% x10087 $2320 =

Ms. Brown received cash dividend on how shares

remaining
How dividend cash
=>
flow is: 1000 -

500) x$6.36 $3188

=

=> Ms.Brown's total cash flow is $2320 $5180 $5,500

+
=

d, Ms. Brown's total cash flow structure

in
parts is the
same as
parta -> capital
the is irrelevant because Ms. Brown can create

her own
leverage or unlevered
of
her stocks create the
to
pay of she desire,
regardless the structure
capital star, Inc.

actually choose

CapitalBudgeting
Question 1:

a. Initial investment:

machine $7,800
Buynew
-

Sell old machine $2,760

+
$3,000
= x (1-40%) $2,400
+

x 40%

Invest in NWC -
$1,000 = -18700 $600
+ -
$500)

Total initial investment -

$6,048

b. OCE

> EBITDA $1,500

= + $600 $2,100
=

<Rep $7,000
=
-

$2,400 $900
=

*OCF EBITDA I-Taxes)

Depreciation,faces $2,100 x (1-40%) $900 x40% $1,688
+
=> x
=

x * =
+
=

c. Terminal

Salvage $$900 185,000 $500) x41 40%3

+> =
-
-
+ (90 907x40%
-

Recovery of NWC $1,000

+

Terminal $1,900
d. Incremental CFS:

yo y1 Y2 73 y4 75 96
 Initial investment -

$6,048
OCF $1,628
+

$1,620
+

+ $1,628 + $1,620 +$1,620 +$1,620

Terminal + $1,900
Increamental its -

$6,040 + $1,628 $1,628

+

+ $1,628 $1,628
+
$1,620
+
+$3,520

e. MV = -$6,040 +

$,x (1-(+13%05) +
$3,500
(1 13%)
+
-
$1348.64

Question 2:

0
$80x1,100 $440005a"x1,400=$28,000 is0
I 2

-
$120,000 scox
-$4,000 2,100=$42,000 = x 1,400:$28,000

$20x2100 $44000$20x2,100 $42,000$20x2,100$42000$20 2,500 $58,000$20 x2500 $50,000

=
=

= x
=

NPV
=>
= -
$120,000 +

[*42900 ( x -

14xxs) 4%4*Yei) x50%+ [**28

=
+
x-mans)$e09+$50(x 50%

=
$27,791.77

Merger and
Acquisition
Question 1

Both debt
a.
firms
have no
outstanding
UB
=> shares
=

outstanding x PPS =2,900 x$39 $113,100 =

V Shares
=

outstanding x PPS 1,400 x$26 $36,400

=
=

Synergy $550 $5,500

=

premium:Cash V7 $29 x 1,400 $36,400 $4,280

Merger
- =
=
-

NPVB Synergy Merger Premium $5,500 $4,200 $1,300

-
= =
-
=

b.
VB Cash synergy $113,100 $29x1,400 $5,500 $14,400
YB-postmergor Y $36,400
=

+ -
+

=
+ - +
-

VB-postmerger $114,400
of mergered firm
=> PPS the is: -
$39.45.
=

Numberoyshares outstanding 2,900

c. Bissue 3 shares for 5shares t

of
shares the
Number
of mergedis:2,900
of firm 3/5 1,400 3,740
+

x =

value the
firm merger V +synergy $113,100 $36,400 $5,500 $155,000
of
is:
= +
+ +
=

=PPS the
of firm merged is
-15000 $49.44
=
Proposition of T's shareholders in Bis: <=

0900 22.45%
=

($113,100 $36,400 $5,5007

Merger premium 22.46% x $36,400 $1,587
-
+
= + -

NPV, Synergy Merge premium $5,500 1 $1587) $7,087

= - -
-
=
=

d, Firm should choose cash offer

because higher
I

of premium.
Indifferent between 2
> offers:
a
=>
Cash
= offer by firm B
VB-post merger in stock
offer

12 1400
x $29 x 1408
2900
=> =

1408
kx
+

$113, 100 +
$36,400 $5,500 +

I x 0.7351
=

Question 2:

NI Number shares $4 x1,600,000 $6,400,000

of your company before merger
is:EPSx
of
=

-
=
·

shares $1x 1,300,000 $1,300,000

by Targetca before merger Number
NI is: EPSx
of
= =

NI of your company aftermarger is:$6,400,000 $1,500,000 $7,500,000

+

=> =

shares $24 x 1,300,000 $31,200,000

of Target Company:
Value PPS Number
a.+>
of
=

x
=

Number share need to

issue to Co. is:
of you pay for target
=>

value of
target company $31,000,000 557,142.86 -
=

pps
ofyour company $56 I

Total shares
of your company after merger
-> is:

1,600,000 557,142.86 2,157,142.86

+

EPS
of your company after merger
=> is:

NI after merger $7,700,000

=
$3.57
=

Total number shares 2,157,142.86

of
↳, value
offered for TargetCo. is:

pps of target so. Numberoyshares (+20%) $24 x 1,300,000

x x (1 20%) $53,040,000
+
x = =

share
Number
=>

of use need to to
buy target Co.
issue is:

value offered
$53,040,000
for Target to.
-
947,142.86
=

pps
of your company
Total shares is:
of company
=> us now

1,600,000 + 947,142.86 2,547,142.86 =

the
= EPS
after merger is

280,000.86
NI after the
merger -- $3.02
=

Total number shares

of
 value the is:value value
c
of merger firm of your company of targetco.
-

$56x 1,600,000 $24x1,300,000 $120,800,000

+
=

=PPS the $120,800,000 $56

after merger
is: =

2157,142.86

= PIE
after the
merge is:
I =15.68
=

your company before merger s A

PIEof the is: =

14
I =

↳PIE
of target Co.
before the
merger
is:
Is:B 24
=

leasing:
a. Quartz's reservation price:
I
mail

CF Quartz:
for
YO y5
Lease minus
buy y13233 44

lease

lease
payment Mar maiz mak mak t
- - -
-

ma
(minus)
Buy
cost the ($840,000)
of equipment
-

Total
$840,000-max-max-Kmak mass-mak

NPV
=>

($840,000-max) +a*
=
x
(1-x+10%034) 0
=

x
=> $201,445.35
=

b, the New reservation

basing company's prize:14 min
CF the
new
basing
for
YO company;1 YL y3 34 y5

Buy machine
the -

$840,000
lease received +
K +min.
1
min
+ 1 + K
min min nein

Takes
payable -minx35% -

1minx35% -

1min *35%
-

mn x 35%
km.in x35%
-

Takes
benefit (Dep. Sheild) $58,800 158,800. $58,800 $58,800 558,800
+ + +
+
+

$840,800x35% -
-

Total $840,0007kmin 4min (-35%) $58,800---- $58,800 -xmin 35%

-
+

x
·
 Interest rate after face is:10% x (1-35%) 6.5%
=

(1-35%) $58,888
$58,800 35%
( 55544)
"man 1min
+
+ -
x

-NPV = -$840,000-min + x - +

0
6.5% x (1 6.5%)5
=

kmin $200, 465.75

=>
=

Short-term Finance:

Dividend
policy
a, EBIT $300
=

Dividend 11-35%) $195

payout $300 x
= =
-

Tax on dividend income $195

=

x 15% $29.25
=

$29.25
Effective
=> tax rate
for corporation 9.75%
=

EBIT

b, P/E 50% = EIA 43

=> =

Under residual div

policy:
total
Div=
NI-target capital structure x
capital budget)
$1000
=
-

143 x 5900) $400

=

PPS
c, repurchase $40 x(1 25%) $50
=
+

Number share $160,000,000

of repurchased 2,000,000
=

=> =

$50

Number share 10 -2m 8m

of remaining
m
=> :

EPS
before repurchase 10m
= $5
=

$50m
EPS
after repurchase =

8m
$6.25
=
1. Capital structure:

MM1 with takes (Formula sheet)

NNAwithout takes

Homemade
leverage (ban shares di
yong ding tinating cty ray)
cho

Repurchase
NI EBIT= -
Takes -

Interest

2.
Capital Budgeting:
OCF: sales-Cash costs -
Takes

TEBIT X11- Taxes) Depreciation

+

x(1-1)
EBITDA
Depreciation xt
+

Initial
1. investment

Initial cost
(Bry new)
opportunitycost
sell ofd=
Mold
-

IMVold -
Bold xtakes

=MVold xH-t) Bold

+

xt

NWC

Total

2. OCF

3. Terminal

Salvage: =PsellxH-t>
Prew-Pold) (1-t) (BUnew-Bold)
=
+
*t

lai
toing atasNIWC trong bait
very
NWC sache to

Adjusted
->
OCF

EAC NDU
=

1 -
xr

1
EAR (1 =

*-
+

1.
(1 r)
+

3. Abandonment
Expansions
4. MSA:

>
Cash
offer: Bacquire A
Premium Grst
= -

VA
A

Premium
NPVB Synergy
-

YB-bigger V +
Vx +
synergy-cash
=
a stock opper:A acquire B

Aissive shares
for share of
B

2
=>
=kXNB
NA xxNB +

Premium:2
mergered Vi
-

Il

Vx+ + synergy

Premium
NPV Synergy
-
=

5.
Leasing:
IF Leasel
for
lease minus
Buy
lease

-lease
payment
benefit (The lease this deductible) lease pat xtakes
Tax
payment are -

Buy (minus)
+ cost

-
loss dep. benefit:Dep x Takes

Total

IF leasor
for

Buy
-

+lease part x (1-t)

+Dep, benefit:Dep xtacces

Total

6. Short
finance:
+Operating cycle Inventory period Account receivable period
= +

cash
= Accounts
payable period -

cycle
Inventory timover=COGS
365
>
Inventory period
=>
-

Average inventory Inventory turnover

Credit sales 365
*
AR turnover= -->
Arperiod:AR turnover
accounts receivable
Average

COAS 365
1) Aptromover= -
->
Ap period =

Average accounts payable Apturnover

 Disburment float: checks written
↳
by a
firm.
Not disburment balance 40

float:Firm's available bal-Firm's bookbalance

Collection float:shecks
+
received
by the
firm. Net collection gloat <0

theatrc+2%
+ 2110,50;ARtry 30
days,tratry longay twin
sales
AR: ACP x
per day
xD:50% khack no Setra
try to con laid 30ngayme tru
negoing,
ASP
=> 50%x10
= 50%x30
+
28
=

ARL
-> = Sale x
Q
10
days
cost Ordering quantity unit
carrying
cost
Carrying per per year
-

2
7 T

cost perondor sales demand per year

thing cost:Fixed
ordering,quantity
a

Number order
Total cost of
of hotching inventory

opitial size
of inventory
order when
carrying
cost
Restocking
=
cost

EOR
=

1
=