Capital Structure

CH-16, 17, 18
P12- Calculating WACC

 Weston Industries has a debt-equity ratio of 1.5. Its WACC is 11

percent, and its cost of debt is 7 percent. The corporate tax
rate is 35 percent.

a. What is Weston's cost of equity capital?

b. What is Weston's unlevered cost of equity capital?

c. What would the cost of equity be if the debt-equity ratio

were 2? What if it were 1.0? What if it were zero?
 Solution
 (a) WACC = (E/V) RE + (D/V) RD (1 – tC) => RE = .2068, or 20.68%
 Weston has a debt-equity ratio of 1.5, which implies the weight of debt is 1.5/2.5
 (b) use M&M Proposition II with taxes
 RE = R0 + (R0 – RD) (D/E) (1 – tC) => R0 = .1392, or 13.92%
 (c) use M&M Proposition II with taxes
 RE = R0 + (R0 – RD) (D/E) (1 – tC) => R0 = .2293, or 22.93%
 With a debt-equity ratio of 1.0, the cost of equity is:
RE = R0 + (R0 – RD) (D/E) (1 – tC) = .1392 + (.1392 – .07)(1)(1 – .35) = .1842, or
18.42%
 With a debt-equity ratio of 0, the cost of equity is:
 RE = .1392 + (.1392 – .07)(0)(1 – .35) = .1392, or 13.92% = R0
P18- Calculating Firm Value

 Cavo Corporation expects an EBIT of $19,750 annually. The

company currently has no debt, and its cost of equity is 15 percent.
 a. What is the current value of the company?
 b. Suppose the company can borrow at 10 percent. If the
corporate tax rate is 35 percent, what will the firm's value be if it
takes on debt equal to 50 percent of its unlevered value? What if it
takes on debt equal to 100 percent of its unlevered value?
 c. What will the firm's value be if it takes on debt equal to 50
percent of its levered value? What if the company takes on debt
equal to 100 percent of its levered value?

 Answer: (a) RE = 20.68% (b) Ru = 13.92% (c) RE = 20.68%, 18.42%, 13.92%

Solution

 (a) With no debt, we are finding the value of an unlevered firm:

 V = EBIT(1 – tC)/R0 = $19,750(1 – .35)/.15 = $85,583.33
(b) VL = VU + tC B
If debt is 50% of VU, then D = (.50) VU
VL = VU + tC[(.50)VU] = $100,560.42
if debt is 100 percent of VU, then D = (1.0) VU
VL = $85,583.33 + .35(1.0)($85,583.33) = $115,537.50
(c ) M&M Proposition I with taxes:
Debt being 50% of the value of the levered firm, D must equal (.50)VL, so:
VL = VU + T [(.50)VL] = = 103,737.37
P21- Cost of Capital

 Acetate, Inc. has equity with a market value of $23 million and debt
with a market value of $7 million. Treasury bills that mature in one year
yield 5 percent per year, and the expected return on the market
portfolio is 12 percent. The beta of Acetate's equity is 1.15. The firm
pays no taxes.

 a. What is Acetate's debt-equity ratio?

 b. What is the firm's weighted average cost of capital?

 c. What is the cost of capital for an otherwise identical all-equity firm?

 Answer: (a) D/E = .30 (b) RWACC = 11.17% (c) Ru = 11.17%

Solution:

 MM without taxes: the cost of capital for an all-equity firm is equal to the
weighted average cost of capital of an otherwise identical levered firm
 Debt-equity ratio = $7,000,000 / $23,000,000 = .30
 RE = .05 + 1.15(.12 – .05) = 13.05%
 RWACC = ($7,000,000/$30,000,000)(.05) + ($23,000,000/$30,000,000)(.1305) =
11.17%
 Modigliani-Miller Proposition II with no taxes:
 RE = R0 + (D/E)(R0 – RD)
 => .1305 = R0 + (.30)(R0 – .05)
 => R0 = .1117, or 11.17%
P-25 MM with Taxes

 Williamson, Inc. has a debt-equity ratio of 2.5. The firm's weighted

average cost of capital is 10 percent, and its pre-tax cost of debt is
6 percent. Williamson is subject to a corporate tax rate of 35
percent.

 a. What is Williamson's cost of equity capital?

 b. What is Williamson's unlevered cost of equity capital?

 c. What would Williamson's weighted average cost of capital be if

the firm's debt-equity ratio were 0.75? What if it were 1.5?

 Answer: (a) RE = 25.25% (b) R0 = 13.33% (c) RWACC = 11.33%

Solution:

 (a) RWACC = [D/(D+E)] (1 – tC)RD + [E/(D+E)] RE

=> 0.10 (.7143)(1 – 0.35)(.06) + (.2857)(RE) => RE = .2525, or 25.25%
 (b) Modigliani-Miller Proposition II with corporate taxes
 RE = R0 + (R0 – RD) (D/E) (1 – tC)
 .2525 = R0 + (2.5)(R0 – .06)(1 – .35) => R0 = .1333, or 13.33%
(c) The cost of levered equity for debt-equity = .75
RE = R0 + (R0 – RD) (D/E) (1 – tC) = 16.91%
RWACC = (.4286)(1 – .35)(.06) + (.5714)(.1691) = 11.33%
P-4 Breakeven EBIT

 Franklin Corporation is comparing two different capital structures,

an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I,
the company would have 315,000 shares of stock outstanding.
Under Plan II, there would be 225,000 shares of stock outstanding
and $4.14 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 a higher EPS?

 b. If EBIT is $1,750,000, which plan will result in the higher EPS?

 c. What is the break-even EBIT?

Answer: (a) Plan I EPS = $1.49 (b) Plan II EPS = $5.94 (c) break-even EBIT = $1,449,000
Solution

(a) Plan I: the unlevered net income is the same as EBIT with no corporate tax.
 EPS = $750,000 / 315,000 shares = $2.38
 Plan II: the levered company, EBIT will be reduced by the interest payment
 NI = $750,000 – .10($4,140,000) = $336,000
 EPS = $336,000 / 225,000 shares = $1.49
(b) Plan I: EPS = $1,750,000 / 315,000 shares = $5.56
Plan II: NI = $1,750,000 – .10($4,140,000) = $1,336,000
EPS = $1,336,000 / 225,000 shares = $5.94
(c) The breakeven EBIT is:
EBIT / 315,000 = [EBIT – .10($4,140,000)] / 225,000
=> EBIT = $1,449,000
P-I Firm Value Ch-17

 Janetta Corp. has an EBIT rate of $975,000 annually, likely to

continue in perpetuity. The unlevered cost of equity for the
company is 14 percent, and the corporate tax rate is 35 percent.
The company also has an outstanding perpetual bond issue with a
market value of $1.9 million.

 a. What is the value of the company?

Solution

 VL = [EBIT(1 – tC)/R0] + tCD

 VL = [$850,000(1 – .35) / .14] + .35($1,900,000) = $4,611,428.57
P-5 Capital Structure and Growth CH-
17
 Edwards Construction currently has debt outstanding with a market
value of $85,000 and a cost of 9 percent. The company has an EBIT
of $7,650 that is expected to continue in perpetuity. Assume there
are no taxes.

 a. What is the value of the company's equity? What is the debt-to-

value ratio?

 b. What are equity value and debt-to-value ratios if the

company's growth rate is 3 percent?
Solution

 Interest payment each year = .09($75,000) = $6,750

 This is exactly equal to the EBIT, so no cash is available for shareholders. Under
this scenario, the value of equity will be zero since shareholders will never
receive a payment. Since the market value of the company’s debt is $75,000, and
there is no probability of default, the total value of the company is the market
value of debt. This implies the debt to value ratio is 1 (one).
 At a growth rate of 3 percent, the earnings next year will be:
 Earnings next year = $6,750(1.03) = $6,952.50
 Payment to shareholders = $6,952.50 – 6,750 = $202.50
 Since there is no risk, the required return for shareholders is the same as the
required return on the company’s debt.
 Value of equity = $202.50 / (.09 – .03) = $3,375.00
P-8 Financial Distress CH-17

 Good Time Company is a regional chain department store. It will

remain in business for one more year. The probability of a boom
year is 60 percent and the probability of a recession is 40 percent. It
is projected that the company will generate a total cash flow of
$185 million in a boom year and $76 million in a recession. The
company’s required debt payment at the end of the year is $110
million. The market value of the company’s outstanding debt is $83
million. The company pays no taxes.

 a. What payoff do bondholders expect to receive in the event of a

recession?

 b. What is the promised return on the company’s debt?

 c. What is the expected return on the company’s debt?

Solution

 (a) The expected payoff to bondholders is the face value of debt or the value of the company,
whichever is less.
 V (in recession) = $76,000,000 ; D (payment required) = $110,000,000; Bondholders will receive
the lesser amount
 (b) Promised RD = (Face value of debt / Market value of debt) – 1
 = ($110,000,000 / $83,000,000) – 1 = 32.56%
 (c) Debt payment received:
 In Boom time = $110,000,000 the entire debt would be recovered
 In recession = $76,000,000
 Expected payment to bondholders = .60($110,000,000) + .40($76,000,000) = $96,400,000
 Expected RD = Expected value of debt / Market value of debt) – 1
 ($96,400,000 / $83,000,000) – 1 = 16.14%
Ch-18 P-2 APV

 Gemini, Inc., an all-equity firm, is considering an investment of $1.4

million that will be depreciated according to the straight-line method
over its four-year life. The project is expected to generate earnings
before taxes and depreciation of $502,000 per year for four years. The
investment will not change the risk level of the firm. The company can
obtain a four-year, 9.5 percent loan to finance the project from a local
bank. All principal will be repaid in one balloon payment at the end of
the fourth year. The bank will charge the firm $45,000 in flotation fees,
which will be amortized over the four-year life of the loan. If the
company financed the project entirely with equity, the firm’s cost of
capital would be 13 percent. The corporate tax rate is 30 percent.
 Using the adjusted present value method, determine whether the
company should undertake the project.
Ch-18 P-14 Beta and Leverage

 Dorman Industries has a new project available that requires an initial

investment of $4.3 million. The project will provide unlevered cash
flows of $710,000 per year for the next 20 years. The company will
finance the project with a debt-to-value ratio of 0.40. The
company’s bonds have a YTM of 6.8 percent. The companies with
operations comparable to this project have unlevered betas of
1.15, 1.08, 1.30, and 1.25. The risk-free rate is 3.8 percent, and the
market risk premium is 7 percent. The company has a tax rate of 34
percent.
 What is the NPV of this project?

 Ans: $1244 K
Ch-18 P-12 APV

 APV MVP, Inc., has produced rodeo supplies for over 20 years. The
company currently has a debt–equity ratio of 50 percent and is in the 40
percent tax bracket. The required return on the firm’s levered equity is 16
percent. The company is planning to expand its production capacity. The
company has arranged a debt issue of $8.7 million to partially finance the
expansion. Under the loan, the company would pay interest of 9 percent at
the end of each year on the outstanding balance at the beginning of the
year. The company would also make year end principal payments of
$2,900,000 per year, completely retiring the issue by the end of the third
year. Using the adjusted present value method, should the company
proceed with the expansion?
 The equipment to be purchased is expected to generate the following
unlevered cash flows:

0 1 2 3
-1,51,00,100 5400000 8900000 8600000
 CH-18 P-15 APV, FTE, WACC
 Newkirk, Inc., is an unlevered firm with expected annual earnings before taxes
of $21 million in perpetuity. The current required return on the firm’s equity is 16
percent, and the firm distributes all of its earnings as dividends at the end of
each year. The company has 1.3 million shares of common stock outstanding
and is subject to a corporate tax rate of 35 percent. The firm is planning a
recapitalization under which it will issue $30 million of perpetual 9 percent debt
and use the proceeds to buy back shares.
 a. Calculate the value of the company before the recapitalization plan is
announced. What is the value of equity before the announcement? What is
the price per share?
 b. Use the APV method to calculate the company value after the
recapitalization plan is announced. What is the value of equity after the
announcement? What is the price per share?
 c. How many shares will be repurchased? What is the value of equity after the
repurchase has been completed? What is the price per share?
 d. Use the flow to equity method to calculate the value of the company’s
equity after the recapitalization.
CH-18 P-17 APV, FTE, WACC

 Bruin Industries just issued $265,000 of perpetual 8 percent debt and

used the proceeds to repurchase stock. The company expects to
generate $123,000 of earnings before interest and taxes in perpetuity.
The company distributes all its earnings as dividends at the end of
each year. The firm’s unlevered cost of capital is 14 percent, and the
corporate tax rate is 40 percent.
 a. What is the value of the company as an unlevered firm?
 b. Use the adjusted present value method to calculate the value of
the company with leverage.
 c. What is the required return on the firm’s levered equity?
 d. Use the flow to equity method to calculate the value of the
company’s equity.
Calculate:

EBITDA
CFO
FCF
FCFE
UFCF
 A comparison table of each metric
EBITDA Operating CF FCF FCFE FCFF
Income Cash Flow Cash Flow Cash Flow Separate
Derived From
statement Statement Statement Statement Analysis
Enterprise
Used to determine Enterprise value Equity value Enterprise value Equity
value
Comparable Comparable
Valuation type DCF DCF DCF
Company Company

Correlation to
Low/Moderate High High Higher Highest
Economic Value

Simplicity Most Moderate Moderate Less Least

GAAP/IFRS metric No Yes No No No

Includes changes
No Yes Yes Yes Yes
in working capital

Includes tax Yes (re-

No Yes Yes Yes
expense calculated)
Includes CapEx No No Yes Yes Yes
 Which of the 5 metrics is the best?

 EBITDA is good because it’s easy to calculate and heavily quoted so most people in
finance know what you mean when you say EBITDA. The downside is EBITDA can
often be very far from cash flow.
 Operating Cash Flow is great because it’s easy to grab from the cash flow statement
and represents a true picture of cash flow during the period. The downside is that it
contains “noise” from short-term movements in working capital that can distort it.
 FCFE is good because it is easy to calculate and includes a true picture of cash flow
after accounting for capital investments to sustain the business. The downside is that
most financial models are built on an un-levered (Enterprise Value) basis so it needs
some further analysis.
 FCFF is good because it has the highest correlation of the firm’s economic value (on
its own, without the effect of leverage). The downside is that it requires analysis and
assumptions to be made about what the firm’s unlevered tax bill would be. This
metric forms the basis for the valuation of most DCF models.
 Why is calculating free cash flow important?
 One can know whether a business is growing or shrinking. it gives a far better understanding of ongoing
operating capital and non cash working capital (operating capital that isn't liquid cash) demands.
 To compare the current quarter or month to previous ones - This can help identify potential areas of
concern, such as declines in revenue or increased capital spending. it is one way how free cash flow can
highlight the need to generate cash or alter your operating activities
 To provide a more realistic view of cash flow - Some businesses may experience significant one-time
expenses that may not represent their actual cash flow over an extended period.
 More accurate financial predictions - Comparing free cash flow to actual spending and income allows
you to forecast future performance better. This can be used to plan for future investments or budgeting
decisions by considering the long-term implications.
 To better understand customer spending trends - By looking at the year-over-year revenue changes, you
can better understand how customers are responding to your offerings, helping you make better
decisions about product development and marketing efforts. In turn, this can help boost sales revenue to
create a rising cash flow.
 To assess how well-capitalized a business is relative to its size and company's industry - If a company has a
solid free cash flow close to its balance sheet, this can indicate that it is well-positioned to handle any
financial issues that may arise.