Solutions to Chapter 8 Problems Problem #1 a.

a. Debt Equity ratio in book value terms Debt is $2,500 and Equity is $2,500 so D/E = $2,500 / $2,500 = 1.0 Debt Equity ratio in market value terms Market Value of Debt = 80% x $2,500 = $2,000 (Debt on the books is recorded at par or face value) Market Value of Equity = 50,000,000 x $80 = $4,000,000,000 (or $4,000 million) Debt Equity ratio at market value = $2,000 / $4,000 = 0.5 b. This question is asking what is the percentage of debt. From a book value, percentage of debt is $2,500 / $5,000 = 0.50 or 50% From a market value, percentage of debt is $2,000 / $6,000 = 0.33 or 33% c. What is the firms after tax cost of debtfind the cost of debt and multiple by (1 0.40) The bonds are selling at a yield of 12%, this is RD so we have 12% x (1 0.40) = 7.2% after-tax cost of debt d. What is the firms cost of equity use the security market line, with the Treasury bond as the risk free rate and the market premium is 5.5% for this set of problems from the heading for the problems and questions section. RE = 8% + 1.2 (5.5%) = 8% + 6.6% = 14.6% e. What is the cost of capitalbook value and market value for D/E Book Value Cost of Capital = 0.5 x 14.6% + 0.5 x 12% x (1 0.40) = 10.9% Market Value Cost of Capital = (2/3) x 14.6% + (1/3) x 12% x (1 0.40) = 12.13% Problem #2 a and b only (Note a perpetuity can be value as CF / r ) a. Does this make sense from the equity investors perspective? If the initial cost of the project is $100 million and the debt/equity ratio is to remain the same, using the market value D/E the equity portion of the investment is: $100 x (2/3) = $66.67 million Now find the cash flow to the equity holders Find the operating cash flow for equity holders (EBIT + Dep taxes interest expense) or Net Income + Depreciation Net Income + Depreciation = $9.60 + $5.0 = $14.60 Now find the NPV of the project = -$66.67 million + $14.60 / 0.1460 = $33.33 million So this is good for the equity holders.

b. From the firms perspective(one could argue that the answer to a is the firms perspective because only owners have a voice in the company) Again find the NPV of the project for the firmit will be the investment of $100 million (outflow) and the operating cash flow (EBIT taxes + Depreciation) and we do not consider the interest expenseits part of the financing decision. OCF = $20 million ($20 million x 0.40) + $5 million = $17 million NPV = -$100 million + $17 million / (0.1213) = $40.11 million So its a go for the firmwhat is happening here is the project earns enough to payback the debt holders with more than enough to cover the cost of equity.

Problem #3 a, b, c and d only a. A change in the D/E borrowing pattern changes the beta of the firm so we need to find the new beta under each option using market value. Step One find the unlevered beta of the company. BetaUNLEVERED = BetaLEVERED / (1 (D/E)(1 TC)) BetaUNLEVERED = 1.2 / (1 + (1/2)(1-0.40)) = 0.923 Option One D/E = ($2,000 - $1,000) / ($4,000 + $1,000) = 1/5 Option One beta = 0.923 x (1 + (1/5)(1-0.40)) = 1.03 Cost of Equity, RE = 8% + 1.03 (5.5%) = 8% + 5.28% = 13.69 Option Two D/E = ($2,000 + $1,000) / ($4,000 - $1,000) = 3/3 Option Two beta = 0.923 x (1 + (1)(1-0.40)) = 1.4769 Cost of Equity, RE = 8% + 1.4769 (5.5%) = 8% + 7.54% = 16.12% Option Three D/E = ($2,000 + $3,000) / ($4,000 - $3,000) = 5/1 Option Three beta = 0.923 x (1 + (5/1)(1-0.40)) = 3.69 Cost of Equity, RE = 8% + 3.69 (5.5%) = 8% + 18.86% = 28.30% b. The RD changes with the bond ratingsafter tax cost of debt is, RD Option One is 11% x (1 0.40) = 6.6% RD Option Two is 13% x (1 0.40) = 7.8% RD Option Three is 18% x (1 0.40) = 10.8% c. The cost of capital under each option is the WACC Option One, WACC = (5/6) x 13.69% + (1/6) x 11% x (1 0.40) = 12.51% Option Two, WACC = (1/2) x 16.12% + (1/2) x 13% x (1 0.40) = 11.96% Option Three, WACC = (1/6) x 28.30% + (5/6) x 18% x (1 0.40) = 13.72%

d. Find the Value of the firm under each of these new WACCs for the firm Note my way is different from the group answers where you find the new firm value with the short-cut way of taking the following: Change in firm value = Prior Firm Value x (Old WACC New WACC)/(New WACC) I am going to substitute the dividend growth rate into the equation Firm Value = CF to Firm x (1+g) / (WACC g) Value of the Firm (before) with current D/E ratio is $6,000 and we find the growth rate via the dividend growth model for the stock price $80 = $4 (1 + g) / (0.146 g) Solving for g we get 0.024 or 2.4% growth rate Note, the dividend growth rate is not the same as the company earnings growth rate but we dont have capital spending or change in net working capital to find g for the company. Step one, Firm Value = Cash Flow to Firm (1+g) / (WACC g) $6,000 = CF to Firm (1.024) / (0.1213 0.024) CF to Firm = $6,000 x (0.0973) / 1.024 = $570.117 million Under Option one new WACC is .01251 so new value of the firm is Firm Value = $570.117 million (1.024) / (0.1251 0.024) = $5,774.5 Decrease in value of $225.5 million Under Option two new WACC is .01196 so new value of the firm is Firm Value = $570.117 million (1.024) / (0.1196 0.024) = $6,106.7 Increase in value of $106.7 million Under Option one new WACC is .01372 so new value of the firm is Firm Value = $570.117 million (1.024) / (0.1372 0.024) = $5,157.2 Decrease in value of $842.8 million For Shareholders they get the residual value under each option so, Option One $5,774.5 - $1,000 = $4,774.5 With new shares sold at $80 the number of new issued shares are, $1,000,000,000 / $80 = 12,500,000 Price per share = $4,774,500,000 / (50,000,000 + 12,500,000) $76.39 Option Two $6,106.7 - $3,000 = $3,106.7 With retired shares bought at $80 the number of issued shares are, Lower by $1,000,000,000 / $80 = 12,500,000 Price per share = $3,106,700 / (50,000,000 - 12,500,000) $82.85

Option Three $5,157.2 - $5,000 = $157.2 With new shares sold at $80 the number of new issued shares are, $3,000,000,000 / $80 = 37,500,000 Price per share = $157,200 / (50,000,000 - 37,500,000) $12.58 Author takes a short-cut to estimate firm value increase with a new WACC. Change in value = Firm value x (Old WACC New WACC) / New WACC Change in Value at Best D/E = $6,000 x (0.1213 - 0.1196)/(0.1196) = $85.3 Million Problem #7 a. Optimal Capital Structure is where WACC is lowestbuild a table with the new beta at each of the discrete borrowing points and recalculate the WACC with the new RE, new RD, and the new D/E. Assumption here is that the outstanding stock remains outstanding. Unlevered firm RE = 9% + 1.5 (5.5%) = 17.25% Levered Beta = Unlevered Beta x (1 + (D/E) x (1 TC)) Levered Beta at 10% = 1.5 x (1 + (1/9)(1- 0.40)) = 1.6 RE at 10% = 9% + 1.6 (5.5%) = 17.80% WACC at 10% = 90% x (17.80%) + (10%) x (10.5%) x (1 0.40) = 16.65% Repeat for each change in debt and fill in the table D / (D + E) D/E 0% -- 0 10% -- 1/9 20% -- 1/4 30% -- 3/7 40% -- 2/3 50% -- 1/1 60% -- 3/2 70% -- 7/3 80% -- 4/1 90% -- 9/1 Rating AAA AA A BBB BB B CCC CC C D RD 10.0% 10.5% 11.0% 12.0% 13.0% 14.0% 16.0% 18.0% 20.0% 25.0% Levered 1.5 1.6 1.725 1.886 2.1 2.4 2.85 3.6 5.1 9.6 RE 17.25% 17.80% 18.49% 19.37% 20.55% 22.20% 24.68% 28.80% 37.05% 61.80% WACC 17.25% 16.65% 16.11% 15.72% 15.45% 15.30% 15.63% 16.20% 17.01% 19.68%

Optimal D/E ratio is 50/50 for UB b. Change one assumptionnow as you sell debt, you retire stock. What is the value of the stock after the sale of debt? From part a, we use the optimal debt level. The market value of equity is:

Find the new firm valuethe author uses an estimation for this process that is not quite right and not demonstrated in the bookbut lacking the growth rate of the company cash flow to the firm, its the best we can do Increase in firm value = $20,000,000 x (0.1725 0.1530) / (0.1530) Increase in firm value = $2,549,020 Total firm value = $22,549,020 But shareholders will hold out for their piece of the increase so New share price = $22,549,020 / 1,000,000 = $22.55 Bond Sale equals 0.50 x $22,549,020 = $11,274,510 Share retired = $11,274,510 / $22.55 500,000 (due to rounded prices) Equity Value = $22,549,020 - $11,274,510 = $11,274,510 Share Price = $11,274,510 / 500,000 = $22.55 Share Price increase of $2.55

Problem #10 (Notice anything strange about the balance sheet?) a. Current cost of equity Again, find the RE, RD, and D/E ratio of the firm. RE = 6% + 1.25 (5.5%) = 12.875% b. Current after-tax cost of debt RD is given with the YTM of 11.0% and tax rate from the income statement is 50% (see EBT $400 and Taxes $200). RD after Tax = 11% x (1 - 0.5) = 5.5% c. Weighted Average Cost of Capital (WACC) D/E using book value of debt and equity, D/E = 1,000 / 1,000 = 1 so E/V = 0.5 and D/V = 0.5 WACC = (0.5) x (12.875%) + (0.5) x (11%) x (1 0.5) = 9.1875% Or using market value of Debt and Equity Market value of debt = 0.90 x $1,000 = $900 million Market value of equity = P/E x Net Income = 9 x $200 = $1,800 million D/E = 1/2 thus E/V = 2/3 and D/V = 1/3 WACC = (2/3) x (12.875%) + (1/3) x (11%) x (1 0.5) = 10.4167% d. The debt for equity swap (we replace some debt with new equity) changes the debt rate to 10% and increases the beta. To find the new beta we first find the unlevered beta and then the new beta at the new debt/equity structure. New debt value is $900 - $200 = $700, new equity value is $1,800 + $200 = $2,000

Unlevered beta = 1.25 / (1 + (1/2)(1-0.5)) = 1.00 unlevered beta New Levered beta = 1.00 x (1 + ($700/$2,000)(1-0.50)) = 1.175 New RE = 6% + 1.175 (5.5%) = 12.4625% e. What is the new WACC? WACC = ($2,000/$2,700) x (12.4625%) + ($700/$2,700) x (10%) x (1 0.50) WACC = 10.53% f. Again, the short-cut estimate of the change in the value of the firm Increase in Firm Value = $2,700 x (0.104167 0.10530) / (0.10530) Increase (decrease) in Firm Value = ($29.051) New Value of the Firm = $2,700 - $29.051 = $2,670.95 Problem #13 a. The current cost of capital, one more time RE = 6.50% + 1.47 (5.5%) = 14.585% RD = 0.30% + 6.50% = 6.80% WACC = $24.27/$27.07 x (14.585%) + $2.8/$27.07 x (6.80%) x (1 -0.40) = WACC for Pfizer = 13.50% b. New Beta for new Debt ratio at 30% (Debt ratio = 3 / (3+7) = 30%) Beta unlevered = 1.47 / (1 + (2.8/24.27) (1 -0.4)) = 1.3748 New Beta at 30% D/E, Beta Lev = 1.3748 x (1 + (3/7) (1 -0.40)) = 1.728 New RE = 6.5% + 1.728 (5.5%) = 16.01% New RD = 6.5% + 2.0% = 8.5% New WACC = (0.70) (16.01%) + (0.30) x (8.5%) x (1 -0.40) = 12.73% c. Now that we have a growth value, we can use the Firm Value formula to find the Cash Flow to the Firm and then the change caused by the new WACC Firm Value = Cash Flow to Firm (1+g) / (WACC g) $27,070 = CF to Firm (1.06) / (0.1350 0.06) CF to Firm = $27,070 x (0.075) / 1.06 = $1,915.330 million Under new structure we have Firm Value = $1,915.3 x (1.06) / (0.1273 0.06) = $30,167.2 million

Impact on the stock price can not be determined per share but we can do an increase in percent form ($30,167.2 - $27,070) / ($24,270) = 12.76% increase in stock price. d. Does the fact that Pfizer have substantial R & D expenses impact its capacity to borrow? Firms with high R & D outflow need more flexibility in use of their cash flow to the firm (from operations) and so tend to borrow less, so yes, it will reduce their debt total. Problem #21 a and b only a. Again, need to find RE, RD, and D/E RD is given = 8.25% Need to find D and here we can use TVM keys if we know, N, I/Y, PMT, and FVunfortunately the author left out the N In the solution he uses 5 years so P/Y = 1 (annual payments) Input 5 8.25 ? 80,000 Variables N I/Y PV PMT Compute 990,084 D is $990,084 E is $6,000,000 D/E = $990,084 / $6,000,000 = 16.50% RE is estimated using beta of similar public firm But similar firms have a D/E of 25% so againbut we have to guess on tax rates so we use the standard 40% from the opening heading Beta unlevered = 1.05 / (1 + (0.25) (1 -0.4)) = 0.913 Beta at 16.5% D/E, BetaLEV = 0.913 x (1 + (16.5%) (1 -0.40)) = 1.0034 RE = 7.0% + 1.0034 (5.5%) = 12.52% WACC = ($6,000 / $6,990) (12.52%) + ($990/$6,990) (8.25%) (1 -0.40) WACC = 11.45% b. Assumption is that the debt does not reduce the equity holdings of the firm. Find new Market Value of Debt = $990,084 x 2 = $1,980,168 New D/E = $1,980,168 / $6,000,000 = 0.33 or 33% Find new beta 1,000,000 FV

Beta at 33% D/E, BetaLEV = 0.913 x (1 + (33%) (1 -0.40)) = 1.0938 New RE = 7% + 1.0938 x (5.5%) = 13.02% WACC = ($6,000 / $7,980) (13.02%) + ($1,980/$7,980) (9%) (1 -0.40) WACC = 11.126% Increase in Firm Value = $6,990 (0.1145 0.1126) / (0.1126) = $117.948 New Firm Value = $6,990 + $990 + $118 = $8,098