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# Topic: Capital Structure Problem Set

Multiple choice questions 1. From the information below, select the optimal capital structure for Viztel Comal Entertainment Company. a. b. c. d. e. Debt = 40%; Equity = 60%; EPS = \$2.95; Stock price = \$26.50. Debt = 50%; Equity = 50%; EPS = \$3.05; Stock price = \$28.90 Debt = 60%; Equity = 40%; EPS = \$3.18; Stock price = \$31.20. Debt = 80%; Equity = 20%; EPS = \$3.42; Stock price = \$30.40 Debt = 70%; Equity = 30%; EPS = \$3.31; Stock price = \$30.00.

2. MagniChip Motors has \$20 million in assets, which are financed with \$4 million of debt and \$16 million of equity. If MagniChips beta is currently 2.4 and its tax rate is 40 percent, what is its unlevered beta? a. b. c. d. 1.503 1.934 2.087 2.400

3. KYM Tech, Inc. has been operating for several years. Its market-determined beta is 2.0, its market value capital structure (Debt/Asset) is 80 percent debt, and its federal-plus-state tax rate is 50 percent. The risk-free rate is 10.0 percent and the required rate of return on the market is 15.0 percent. What is Old Air's asset (unlevered) beta? a. 0.67 b. 1.00 c. 1.33 d. 1.67 e. 2.00

4. What appears to be the targeted debt ratio of a firm that issues RM20 million in bonds and RM30 million in equity to finance new projects? a. b. c. d. 15% 20% 40% 66.67%

5. The company cost of capital for a firm with 40/60 debt/equity split, 8% cost of debt, 15% cost of equity and a 40% tax rate would be: a. b. c. d. 8.88% 10.80% 10.92% 12.20%

6. ParadeOCI Group currently has RM50,000,000 of liabilities and common equity in combination. The firm has no Preferred Stock. After careful evaluation, the CFO constructed the following table to show the CEO the effect of changing the firms capital structure:

## Market Price Per Share RM125.50 RM130.75 RM130.00 RM128.05

According to this information, what is ParadeOCIs optimal capital structure? a. 20 percent debt; 80% equity b. 40 percent debt; 60% equity c. 60 percent debt; 40% equity

7. A firm has a debt-to-equity ratio of 1.0. If its cost of capital is 13% and cost of debt is 10%, what is the cost of equity if there are no taxes? a. b. c. d. 3.00% 23.00% 15.00% 16.00%

8. From the information below, select the optimal capital structure for Viztel Comal Entertainment Company. f. g. h. i. j. Debt = 40%; Equity = 60%; EPS = \$2.95; Stock price = \$26.50. Debt = 50%; Equity = 50%; EPS = \$3.05; Stock price = \$28.90 Debt = 60%; Equity = 40%; EPS = \$3.18; Stock price = \$31.20. Debt = 80%; Equity = 20%; EPS = \$3.42; Stock price = \$30.40 Debt = 70%; Equity = 30%; EPS = \$3.31; Stock price = \$30.00.

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The following information applies to Lott Enterprises: Operating income (EBIT) Debt Interest expense Tax rate \$300,000 \$100,000 \$ 10,000 40% Shares outstanding EPS Stock price 120,000 \$1.45 \$17.40

The company is considering a recapitalization where it would issue \$348,000 worth of new debt and use the proceeds to buy back \$348,000 worth of common stock. The buyback will be undertaken at the pre-recapitalization share price (\$17.40). The recapitalization is not expected to have an effect on operating income or the tax rate. After the recapitalization, the companys interest expense will be \$50,000. Assume that the recapitalization has no effect on the companys price earnings (P/E) ratio. What is the expected price of the companys stock following the recapitalization?

a. b. c. d. e. 1.

## Capital structure and stock price

We can do this problem by using the P/E before and after the recapitalization. Recall that P/E = Price/EPS. Before recap. After recap. EBIT \$300,000 \$300,000 Interest -10,000 -50,000 EBT \$290,000 \$250,000 Tax (40%) 116,000 100,000 NI \$174,000 \$150,000 Shares 120,000 100,000* EPS \$174,000/120,000 = \$1.45. \$150,000/100,000 = \$1.50. P/E \$17.40/1.45 = 12. *120,000 - (\$348,000/\$17.40) = 100,000 shares. As P/E = 12 after the recapitalization (recall the question states that it does not change), we know 12 = Price/\$1.50; Price = 12 \$1.50 = \$18.00. Flood Motors is an all-equity firm with 200,000 shares outstanding. The companys EBIT is \$2,000,000, and EBIT is expected to remain constant over time. The company pays out all of its earnings each year, so its earnings per share equals its dividends per share. The companys tax rate is 40 percent. The company is considering issuing \$2 million worth of bonds (at par) and using the proceeds for a stock repurchase. If issued, the bonds would have an estimated yield to maturity of 10 percent. The risk-free rate in the economy is 6.6 percent, and the market risk premium is 6 percent. The companys beta is currently 0.9, but its investment bankers estimate that the companys beta would rise to 1.1 if it proceeds with the recapitalization. Assume that the shares are repurchased at a price equal to the stock market price prior to the recapitalization. What would be the companys stock price following the recapitalization? a. b. c. d. e. \$51.14 \$53.85 \$56.02 \$68.97 \$76.03

10.

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The following information applies to Lott Enterprises: Operating income (EBIT) Debt Interest expense Tax rate \$300,000 \$100,000 \$ 10,000 40% Shares outstanding EPS Stock price 120,000 \$1.45 \$17.40

The company is considering a recapitalization where it would issue \$348,000 worth of new debt and use the proceeds to buy back \$348,000 worth of common stock. The buyback will be undertaken at the pre-recapitalization share price (\$17.40). The recapitalization is not expected to have an effect on operating income or the tax rate. After the recapitalization, the companys interest expense will be \$50,000. Assume that the recapitalization has no effect on the companys price earnings (P/E) ratio. What is the expected price of the companys stock following the recapitalization? a. b. c. d. e. 12. \$15.30 \$17.75 \$18.00 \$19.03 \$20.48

A consultant has collected the following information regarding Young Publishing: Total assets Operating income (EBIT) Interest expense Net income Share price \$3,000 million \$800 million \$0 million \$480 million \$32.00 Tax rate Debt ratio WACC M/B ratio EPS = DPS 40% 0% 10% 1.00 \$3.20

The company has no growth opportunities (g = 0), so the company pays out all of its earnings as dividends (EPS = DPS). Youngs stock price can be calculated by simply dividing earnings per share by the required return on equity capital, which currently equals the WACC because the company has no debt. The consultant believes that the company would be much better off if it were to change its capital structure to 40 percent debt and 60 percent equity. After meeting with investment bankers, the consultant concludes that the company could issue \$1,200 million of debt at a before-tax cost of 7 percent, leaving the company with interest expense of \$84 million. The \$1,200 million raised from the debt issue would be used to repurchase stock at \$32 per share. The repurchase will have no effect on the firms EBIT; however, after the repurchase, the cost of equity will increase to 11 percent. If the firm follows the consultants advice, what will be its estimated stock price after the capital structure change? a. b. c. d. e. \$32.00 \$33.48 \$31.29 \$32.59 \$34.72

13. AJCroft Sdn. Bhd. currently has RM200,000 debt outstanding carrying a coupon rate of 6 percent. Its earnings before interest and taxes (EBIT) are RM100,000, and it is a zero-growth company. The companys cost of equity is 10 percent, and its tax rate is 27%. The company has 10,000 shares of common stock outstanding. The dividend payout ratio is 100%.

AJCroft Sdn. Bhd. Is considering recalling the 6 percent debt by issuing RM400,000 new 7 percent debt. The new funds would be used to replace the old debt and to repurchase stock at the existing price. It is estimated that the increase in riskiness resulting from the leverage increase would cause the required rate of return on equity to increase to 11 percent. If this plan is carried out, what would be the companys new stock price? A. B. C. D. RM60.00 RM62.00 RM64.24 RM69.37

14. KeladiGPA Sdn. Bhd. has a constant growth rate of 7 percent. The company retains 30 percent of its earning to fund future growth. KeladiGPA expected EPS and k s for various capital structures are given below. What is the optimal capital structure for GOODWAY? Debt/Total Assets 20% 30% 40% 50% 60% a. b. c. d. Expected EPS RM2.50 RM3.00 RM3.25 RM3.75 RM4.00 ks 15.0% 15.5% 16.0% 17.0% 18.0%

Debt/Total Assets = 20% Debt/Total Assets = 30% Debt/Total Assets = 40% Debt/Total Assets = 50%

## Section B: Problem Set.

Question 1 Promto KPK Inc.s target capital structure is 20 percent debt, 5 percent preferred stock, and 75 percent common stock. Assume that the firms af ter-tax yield to maturity on its bond is 6 percent, and that the investors require a 7.5 percent return on Promto preferred stock and a 15 percent return on its common stock. What is Promto KPKs WACC? WACC = WdKd(1-t) + WpKp + WeKe = 0.20(6%) + 0.05(7.5%) + 0.75 (15%) = 12.825%

Question 2 Paramo Corporations common stock is currently selling for RM750. Last years dividend was RM55.00 per share. Investors expect dividend to grow at an annual rate of 9 percent indefinitely. Flotation costs of 5 percent will be incurred when the new stock is sold. a. What is the cost of internal common equity? Po = D1 k g : k = D1 + g Po k = RM55 (1+9%) + 9% = 16.99% RM750 b. What is the cost of new common equity? k = RM55 (1+9%) + 9% = 17.41% RM750 (1-5%) Question 3 Last year BKatil Sdn. Bhd. had RM50 million in total assets. Management desires to increase its plant and equipment during the coming years by RM12 million. The company plans to fianc 40 percent of the expansion with debt and the remaining 60 percent in equity capital. Bond financing will be at 9 percent rate and will be sold at par value. Common stock is currently selling for RM50 per share, and flotation costs foe new common stock will amount to RM5 per share. The expected dividend next year for BKatil is RM 2.50. Furthermore, dividend is expected to grow at a 6 percent rate into the future. The marginal corporate tax rate is 28 percent. Internal funding available from additions to retained earning is RM4000000. a. What amount of new stock must be sold if existing capital structure is to be maintained? Budget expansion = RM12 million Equity needed 60% = RM7200000 Less: retained earning = (RM4000000) Issue of new Common Stock = RM3200000

b. Calculate the weighted marginal cost of capital at an investment level of RM12 million. Kd = 9% (1- 28%) = 6.48% K new stock : K = Di +g= Po (1-F) RM2.50 + 0.06 = 11.56% RM50 RM5

## WACC = 0.40 (6.48%) + 0.60 (11.56%) = 9.528%

Question 4 TancoTMR Sdn. Bhd., a producer of turbine generator, is in this situation; EBIT = RM4.0 million; Tax Rate = 35%; debt outstanding = D = RM2.0 million; Kd = 10%; Ks = 15%; share of stock outstanding = N 0 = 600000; and book value per share = RM10.00. Since TancoTMRs product market is stable and the company expects no growth, all earnings are paid out as dividends. The debt consists of perpetual bonds. a. What are TancoTMRs earning per share (EPS) and its price per share (P0)?

EBIT Interest : RM2.0 million x Kd = 10%; EBT Tax 35% EAT EPS = Earning After Tax No of Share Outstanding Po = Div / Ks ; since all earning is paid out as dividend; then EPS = DPS

RM ,000 4000 (200) 3800 (1330) 2470 2470 = 4.1167 600 4.1167 = RM27.44 0.15

## Debt Total Outstanding = RM2.0 million

Wd = RM2.0 / RM8.0 million = 25% Kd = 10%, Tax = 35% WACC = WdKd(1-T) + WsKs = 0.25 . 10% (1-35%) + 0.75 (15%) = 1.625 + 11.25 = 12.875%

Equity Total Outstanding = 600000 shares x RM10 = RM6000000 Ws = RM6.0 / RM8.0 = 75% Ks = 15%

c.

TancoTMR can increase it debt by RM8.0 million, to a total of RM10.0 million, using the new debt to buy back and retire some of the shares at current price. Its interest rate on debt will be 12% (it will have to call and refund the old debt), and its costs of new equity will rise from 15% to 17%. EBIT will remain constant. Should TancoTMR change its capital structure?

EBIT Interest : RM10.0 million x Kd = 12%; EBT Tax 35% EAT EPS = Earning After Tax No of Share Outstanding Po = Div / Ks ; since all earning is paid out as dividend; then EPS = DPS *Retirement of Shares: Increase in debt = RM8.0 million Current Price of Share = RM27.44 per share No of Share retired = RM8.0 million / RM27.44 per share = 291546 shares Balance Share outstanding = 600000 291546 shares = 308454 shares Since Po increase from RM27.44 in (a) to RM34.71 in ( c) then debt RM10 million (and call and refund the old debt of RM2.0 million)

RM ,000 4000 (1200) 2800 (980) 1820 1820000 =5.90 308454* 5.90 =RM34.71 0.17

should be increased to

d. If TancoTMR did not have to refund the old debt of RM2.0 million, how would this effect thing? RM ,000 EBIT 4000 Interest : RM2.0 million x Kd = 10%; (200) RM8.0 million x Kd = 12%; (960) EBT 2840 Tax 35% (994) EAT 1846 EPS = Earning After Tax 1846000 =5.98 No of Share Outstanding 308454* Po = Div / Ks ; since all earning is paid out as dividend; then EPS = 5.98 =RM35.17 DPS 0.17 *Retirement of Shares: Increase in debt = RM8.0 million Current Price of Share = RM27.44 per share No of Share retired = RM8.0 million / RM27.44 per share = 291546 shares Balance Share outstanding = 600000 291546 shares = 308454 shares Since Po increase from RM27.44 in (a) to RM35.17 in ( d) then debt should be increased to RM10 million (but do not call and refund the old debt of RM2.0 million)

e. What is TancoTMR TIE coverage ratio under the original situation and under the condition in part (c) of this question?

## RM ,000 4000 (1200) 2800 4000 1200

= 20x

= 3.33x

Question 5 Saptech Patimas Sdn. Bhd. is tryig to determine its optimal capital structure. The company capital structure consist of debt and common stock. In order to estimate the cost of debt, the company produced the following table: Debt / Asset Ratio 0.10 0.20 0.30 0.40 0.50 Equity / Asset Ratio 0.90 0.80 0.70 0.60 0.50 Debt / Equity Ratio 0.11 0.25 0.43 1.67 1.00 Bond Rating AA A A BB B Before-tax Cost of debt 7.0% 7.2 8.0 8.8 9.6

The company tax rate , T, is 40% The company uses the CAPM to estimate its cost of common equity, ks. The risk-free rate is 5 percent and the market risk premium , km krf, is 6 percent. Saptech Partimas estimates that if it has no debt beta would be 1.0. (its unlevered beta, bu). On the basis of this information, what is the companys optimal capital structure, and what is the firms weighted cost of capital (WACC). (10 marks) Use the following table to determine the WACC: D/E b Ks Wc Kd Wd WACC

Formula:

## WACC Note 7 10.68* 10.38 10.22 10.15 10.18

note* Note 1: D/E = (D/A) / (1-D/A) = 0.10/(1-0.10) = 0.1111 2 marks Note 2: b = bu(1+(1-T)(D/E))= 1.0((1+(1-0.40)0.1111)) = 1.0667 2 marks Note 3: ks = krf (km-krf)b = 5% + (6%)1.0667=11.40% - 2 marks Note 4: Wc = Given as per questions

Note 5: kd = Given as per questions Note 6: Wc = 0.90: Wd = 0.10 = 100% - 2 marks Note 7: WACC = WcKs + Wd Kd(1-T) = 0.90(11.4%)+ 0.10(7%)(1-40%) = 10.68% - 2 marks

Question6: Capital Structure Zippy Pasta Corporation (ZPC) has a constant growth rate of 7 percent. The company retains 30 percent of its earnings to fund future growth. ZPCs expected EPS (EPS 1) and ks for various capital structures are given below. What is the optimal capital structure for ZPC? (hint: you need to calculate the Price of the Share)

## * optimal capital structure

Question 7: Currently, IOI Corp. has a capital structure consisting of 20 percent debt and 80 percent equity. IOI Corp. debt currently has an 8 percent yield to maturity. The risk-free rate (krf) is 5 percent, and the market risk premium (km-krf) is 6 percent. Using the CAPM, IOI Corp. estimates that the cost of equity is currently 12.5 percent. The company has a 28% tax rate. 1. What is IOI Corp. current WACC? (2 marks)

WACC = 0.20 (8%) (1-28%) + 0.80 (12.5%) = 11.312% - marks each item. 2. What is the current beta () on IOI Corp. common stock? (1 mark) Ke = krf + (km-krf)

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12.5% = 5%+ (6%) = (12.5 5) / 6 = 1.25 3. What would be IOI Corp. beta () if the company has no debt in its capital structure (b u). (1 mark) Bu = b / (1+(1-T)(D/E)) 1.25 /(1 + (1-28%) (20%/80%)) 1.25/1.18 = 1.059 4. IOI Corp. is considering changing its capital structure to 40 percent debt and 60 percent equity. If the company went ahead with the proposed change, the yield to maturity of the companys bond would rise to 9.5%; and the beta (b40%) would also changed to 1.567. What would you advise IOI Corp.? (3 marks) ks = kRF + (kM - kRF)b ks = 5% + (6%)1.567 ks = 14.40%. 1 mark WACC = wdkd(1 - T) + wcks WACC = (0.4)(9.5%)(1 - 0.28) + (0.6)(14.40%) WACC = 11.376%. 1 mark The firm should be advised not to proceed with the recapitalization as it causes the WACC to increase from 11.312% to 11.376%. As a result, the recapitalization would lead to an decrease in firm value (drop in Price of the share). 1 mark Question 8 (A) Hijaz Electronics Sdn. Bhd. has made the following forecast for the upcoming year based on the companys current capitalization: Interest expense Operating income (EBIT) Earnings per share RM2,000,000 RM20,000,000 RM3.60

The company has RM20 million worth of debt outstanding and all of its debt yields 10 percent. The companys tax rate is 26 percent. The companys price earnings (P/E) ratio has traditionally been 12, The companys investment bankers have suggested that the company recapitalize. Their suggestion is to issue enough new bonds at a yield of 10 percent to repurchase 1 million shares of common stock. Assume that the stock can be repurchased at todays RM40 stock price. Assume that the repurchase will have no effect on the companys operating income; however, the repurchase will increase the companys dollar interest expense. Also, assume that as a result of the increased financial risk the companys price earnings (P/E) ratio will be 11.5 after the repurchase.

REQUIRED: a) What is the net income before the change? b) How many shares are currently outstanding? c) What is the current stock price? d) What would be the expected year-end stock price if the company proceeded with the recapitalization? Should Hijaz proceed with the recapitalization?

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a. Before recapitalization: EBIT RM20,000,000 Interest 2,000,000 EBT RM18,000,000 Taxes (26%) 4,680,000 NI RM13,320,000 b. EPS = RM3.60. Shares outstanding = RM13,320,000/RM3.60 = 3,700,000 shares. c. P/E Ratio = 12 P/3.60 = 12 = 3.60 x 12 = 43.20 d. After recapitalization: New shares = 3.7 million - 1 million = 2.7 million shares. Total debt = RM20,000,000 + (1,000,000)(RM40) = RM60,000,000. Interest payment = (RM60,000,000)(0.1) = RM6,000,000.

Net income: EBIT RM20,000,000 Interest 6,000,000 EBT RM14,000,000 Taxes (26%) 3,640,000 NI RM 10,360,000 EPS = RM10,360,000/2,700,000 = RM3.84. P/E = 11.5

Question 9 (a) A consultant has collected the following information regarding Young Publishing: Total assets Operating income (EBIT) Interest expense Earning Share price \$3,000 million \$800 million \$0 million \$480 million \$32.00 Tax rate Debt ratio WACC M/B ratio EPS = DPS 40% 0% 10% 1.00 \$3.20

The company has no growth opportunities (g = 0), so the company pays out all of its earnings as dividends (EPS = DPS). Youngs stock price can be calculated by simply dividing earnings per share by the required return on equity capital, which currently equals the WACC because the company has no debt. The consultant believes that the company would be much better off if it were to change its capital structure to 40 percent debt and 60 percent equity. After meeting with investment bankers, the consultant concludes that the company could issue \$1,200 million of debt at a before-tax cost of 7 percent, leaving the company with interest expense of \$84 million. The \$1,200 million raised from the debt issue would be used to repurchase stock at \$32 per share. The re purchase will have no effect on the firms EBIT; however, after the repurchase, the cost of equity will increase to 11 percent. If the firm follows the consultants advice, what will be its estimated stock price after the capital structure change? REQUIRED:

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## i. ii. iii. iv.

Determine the current number of shares outstanding: Determine the number of shares after the repurchase: Determine the new EPS after the repurchase: Determine the new stock price:

1.

Capital structure and stock price Step 1: Find the current number of shares outstanding: Shares = NI/EPS = \$480 million/\$3.20 = 150 million shares.

Step 2:

Find the number of shares after the repurchase: New shares = 150 \$1,200/\$32 = 150 37.5 = 112.5 million shares. Find the new EPS after the repurchase: EPS = [(EBIT INT)(1 - T)]/New shares = [(\$800 \$84) 0.6]/112.5 = \$3.818667. Find the new stock price: Stock price = EPS/New WACC = \$3.818667/0.11 = \$34.72.

Step 3:

Step 4:

Question 10 (a) KUBCom Sdn. Bhd. Has an expected dividend payout ratio of 50 percent, a required rate of return of 12 percent and a dividend growth rate of 6 percent. If you expect next years earning to be RM4.00 per share, what is the value of the stock today? P0 = 0.50(4)/12-6) RM33.33 (b) Newco Sdn. Bhd. has 20,000 shares outstanding and an earning of RM100,000. The current stock price is RM40. What effect does a 5% stock repurchase have on the price per share of Newco's stock? (Assuming the company maintain the current P/E ratio)

Newco's current EPS = RM100,000/20,000 = RM5 per share P/E ratio = RM40/RM5 = 8x With a 5% stock repurchase, the following occurs: Newco's shares outstanding are reduced to 19,000 shares (20,000 x (1-.05)) Newco's EPS = RM100,000/19,000 = RM5.26 P/E ratio = 8 P/5.26 = 8 P = 5.26 x 8 = RM42.08

(c) NHFatt Sdn. Bhd. anticipates that its earnings (before recapitalization) at the end of the year will be RM7.3 million. The company currently has 900,000 shares of common stock outstanding and has no debt. The company stocks trade at RM40. The company is considering a recapitalization where it will issue RM10.0 million worth of debt at a yield to maturity of 10 percent and use the

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proceed to repurchase common stock. Assume the stock price remains unchanged by the transaction, and the company tax rate is 27%. What will the company earning per share if it proceeds with the recapitalization. before recapitalization x nil x x 7.30 million after recapitalization 10.0 million (1.0 million) 9.0 million (2.43 million) 6.57 million EPS = 6,570,000/650,000 shares = RM10.11

EBIT i. Interest EBT ii. Tax 27% iii. Earning iv. This means EBIT/EBT = 7.30/(1-27%) = RM10.0 million Interest = 0 Share outstanding Repurchase = 10,000,000 / 40 Balance outstanding = 900,000 = 250,000 650,000 shares

Question 10 [a] JTiasa Sdn. Bhd. is considering two alternative capital structures one is conservative and the other aggressive. The conservative capital structure calls for a Debt/Asset ratio = 0.25, while the aggressive strategy calls for a Debt/Asset of =0.75. The firm estimate its total asset to be RM400,000. The book value of equity per share under either scenario is RM10.00 per share. Once the firm selects its target capital structure it envisions two possible scenarios for its operations: Scenario 1- Conservative Debt/Asset = EBIT Kd Tax rate 0.25 RM60,000 10% 26% Scenario 2 Aggressive Debt/Asset = EBIT kd Tax rate 0.75 RM80,000 12% 26%

REQUIRED: What is the difference between the Earning Per Share [EPS] between the 2 scenarios? Scenario 1 400,000 100,000 / 300,000 / 60,000 [10,000] 10% 100,000 / 50,000 [13,000] / 37,000 Scenario2 400,000 300,000 / 100,000 / 80,000 [36,000] 12% 300000/ 44,000 [11,440]/ 32,560

Assets Debt 25% / 75% of asset thus - Equity EBIT Interest EBT Tax 26% Earning

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No of shares EPS

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