# Chapter 16

Problems 1-22
Input boxes in tan Output boxes in yellow Given data in blue Calculations in red Answers in green
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Chapter 16
Question 1 Input Area:

Market value EBIT Expansion-EBIT Recession-EBIT Debt issue Interest rate Shares outstanding

\$ \$

\$

250,000 28,000 30% 50% 90,000 7% 5,000

Output Area:

No debt EBIT Interest NI EPS Change EPS%

\$ \$ \$ \$

14,000 14,000 2.80 -50.00%

\$ \$ \$ \$

28,000 28,000 5.60 0.00%

\$ \$ \$ \$

36,400 36,400 7.28 30.00%

With debt Share price = \$ Shares repurchased = EBIT Interest NI EPS Change EPS% \$ \$ \$ \$

50.00 1,800.00 14,000 6,300 7,700 2.41 -64.52% \$ \$ \$ \$ 28,000 6,300 21,700 6.78 0.00% \$ \$ \$ \$ 36,400 6,300 30,100 9.41 38.71%

Chapter 16
Question 2 Input Area:

Market value EBIT Expansion-EBIT Recession-EBIT Debt issue Interest rate Shares outstanding Tax rate

\$ \$

\$

250,000 28,000 30% 50% 90,000 7% 5,000 35%

Output Area:

No debt with taxes EBIT Interest Taxes NI EPS Change EPS%

\$

\$ \$

14,000 4,900 9,100 1.82 -50.00%

\$

\$ \$

28,000 9,800 18,200 3.64 0.00%

\$

\$ \$

36,400 12,740 23,660 4.73 30.00%

With debt and taxes Share price = \$ Shares repurchased = EBIT Interest Taxes NI EPS Change EPS% \$

50.00 1,800.00 14,000 6,300 2,695 5,005 1.56 -64.52% \$ 28,000 6,300 7,595 14,105 4.41 0.00% \$ 36,400 6,300 10,535 19,565 6.11 38.71%

\$ \$

\$ \$

\$ \$

Chapter 16
Question 3 Input Area:

No debt TE = MV = With debt TE =

\$

250,000

\$

160,000

Output Area:

a. ROE Change ROE% b. ROE Change ROE % c. No debt No debt, ROE Change ROE % With debt With debt, ROE Change ROE %

5.60% -50.00% 4.81% -64.52%

11.20% 0.00% 13.56% 0.00%

14.56% 30.00% 18.81% 38.71%

3.64% -50.00%

7.28% 0.00%

9.46% 30.00%

3.13% -64.52%

8.82% 0.00%

12.23% 38.71%

Chapter 16
Question 4 Input Area:

Plan I: Shares outstanding Plan II: Shares outstanding Debt outstanding Interest rate a. EBIT b. EBIT

160,000

\$

80,000 2,800,000 8% 350,000 500,000

\$ \$

Output Area:

a. Plan I Plan II b. Plan I Plan II c. Breakeven EBIT = \$ \$ \$ \$

NI 350,000 126,000 500,000 276,000

EPS \$ \$ \$ \$ \$ 2.19 1.58 3.13 3.45 448,000.00

Chapter 16
Question 5 Input Area:

Plan I: Shares outstanding Plan II: Shares outstanding Debt outstanding Interest rate a. EBIT b. EBIT

160,000

\$

80,000 2,800,000 8% 350,000 500,000

\$ \$

Output Area:

Price V (I) V (II)

\$ 35.00 \$ 5,600,000.00 \$ 5,600,000.00

Chapter 16
Question 6 Input Area:

Plan I: Shares outstanding Debt Plan II: Shares outstanding Debt outstanding Interest rate a. EBIT All-equity shares d. Tax rate

\$

7,000 160,000 5,000 240,000 10% 39,000 11,000 40%

\$

\$

Output Area:

a. EBIT Interest NI EPS \$ \$ \$ \$

I 39,000 16,000 23,000 3.29 \$ \$ \$ \$

II 39,000 24,000 15,000 3.00 \$ \$ \$ \$

All-Equity 39,000 39,000 3.55

EBIT b. Plan I vs. all equity \$ 44,000 Plan II vs. all equity \$ 44,000 The break even levels of EBIT are the same because of M&M Proposition I. c. Breakeven EBIT: Plan I vs. Plan II \$ 44,000 This break-even level of EBIT is the same as in part (b) again, because of M&M Proposition (I). d. EBIT Interest Taxes NI EPS Breakeven EBIT Plan I vs. all-equity \$ \$ \$ \$ \$ I 39,000 16,000 9,200 13,800 1.97 \$ \$ \$ \$ \$ II 39,000 24,000 6,000 9,000 1.80 \$ \$ \$ \$ \$ All-equity 39,000 15,600 23,400 2.13

\$

44,000

Plan II vs. all-equity PLanI vs. Plan II

\$ \$

44,000 44,000

The break-even levels of EBIT do not change because of additions of taxes reduces the income of all three plans by the same percentage; therefore they do not change relative to one another.

Chapter 16
Question 7 Input Area:

Plan I: Shares outstanding Debt Plan II: Shares outstanding Debt outstanding Interest rate

\$

7,000 160,000 5,000 240,000 10%

\$

Output Area:

Price (I) \$ 40.00 Price (II) \$ 40.00 This shows that when there are no corporate taxes, the stockholder does not care about the capital structure decision of the firm. This is M&M Proposition I without taxes.

Chapter 16
Question 8 Input Area:

Debt percentage Shares outstanding Price EBIT Interest rate Shareholder: Shares owned

\$ \$

35% 8,000 55 32,000 8% 100

Output Area:

a. EPS Shareholder's cash flow b. V D Shares bought NI EPS Shareholder's cash flow c.

\$ \$ \$ \$ \$ \$ \$

4.00 400.00 440,000 154,000 2,800 19,680 3.78 378.46

Sell 35 shares of stock and lend the proceeds at 8% Interest cash flow \$ 154.00 Cash flow from shares held \$ 246.00 Total cash flow \$ 400.00

d. The capital structure is irrelevant because shareholders can create their own leverage or unlever the stock to create the payoff they desire, regardless of the capital structure the firm actually chooses.

Chapter 16
Question 9 Input Area:

ABC: All-equity XYZ: Stock value Interest rate EBIT Stockholder: Owns XYZ

\$ \$

600,000 300,000 8% 80,000

\$

\$

30,000

Output Area:

a. EBIT Stockholders CF Return

\$ \$

56,000 5,600 18.67%

b. Sell all XYZ shares: nets \$ 30,000 Borrow \$ 30,000 at 8% Interest cash flow = \$ (2,400.00) Use the proceeds from selling shares and the borrowed funds to buy ABC shares: Stock cash flow (ABC) \$ 8,000 Total cash flow \$ 5,600 Rate 18.67% c. ABC: RE XYZ: RE 13.33% 18.67%

d. ABC: WACC 13.33% XYZ: WACC 13.33% When there are no corporate taxes, the cost of cost of capital for the firm is unaffected by the capital structure, this is M&M Proposition II without taxes.

Chapter 16
Question 10 Input Area:

WACC Value of equity

\$

9% 23,000,000

Output Area:

EBIT

\$

2,070,000

Chapter 16
Question 11 Input Area:

WACC Value of equity Tax rate

\$

9% 23,000,000 35%

Output Area:

EBIT \$ 3,184,615.38 WACC 9.00% Due to taxes, EBIT for an all-equity firm would have to be higher for the firm to still be worth \$25M.23,000,000 \$

Chapter 16
Question 12 Input Area:

Debt-equity ratio WACC Cost of debt Tax rate c. Debt-equity ratio Debt-equity ratio Debt-equity ratio

1.5 10% 7% 35% 2.00 1.00 0.00

Output Area:

a. RE b. RU c. RE I RE II RE III

18.18% 12.66% 20.01% 16.34% 12.66%

Chapter 16
Question 13 Input Area:

Interest rate WACC Tax rate b. Convert to debt c. Convert to debt

8.20% 11% 35% 25% 50%

Output Area:

a. b. c. d.

All-equity financed RE RE WACC(B) WACC(C)

11.00% 11.61% 12.82% 10.04% 9.08%

Chapter 16
Question 14 Input Area:

EBIT Interest rate Cost of equity Tax rate Amount borrowed

\$

\$

92,000 9% 15% 35% 60,000

Output Area:

VU V

\$ \$

398,666.67 419,666.67

Chapter 16
Question 15 Input Area:

EBIT Interest rate Cost of equity Tax rate Borrows VU V

\$

\$ \$ \$

92,000 9% 15% 35% 60,000 398,667 419,667

Output Area:

RE 15.65% WACC 14.25% 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.

Chapter 16
Question 16 Input Area:

EBIT \$ Tax rate Outstanding debt \$ Interest rate Unlevered cost of capital

64,000 35% 95,000 8.50% 15.00%

Output Area:

VU VL

\$ \$

277,333.33 310,583.33

Applying M&M Proposition I with taxes, the firm has increased its value by issuing debt. As long as M&M Proposition I holds, that is, there are no bankruptcy costs and so forth, then the company should continue to increase its debt/equity ratio to maximze the value of the firm.

Chapter 16
Question 17 Input Area:

EBIT Perpetuity Cost of equity Interest rate Tax rate Convert to debt Convert to debt

\$

14,000 16% 9% 35% 50% 100%

Output Area:

No debt: VU Debt Debt

50% 100%

\$ \$ \$

56,875.00 66,828.13 76,781.25

Chapter 16
Question 18 Input Area:

Projected operating income Year-end interest on debt Market value of stock Market value of debt Investor borrowing rate Amount of equity to buy

\$ \$ \$ \$

Veblen 400,000 2,500,000 6% 5%

Output Area:

a. Investment in Knight Investment in Veblen Amount to borrow Year-end cash flow from Knight Year-end cash flow from Veblen Interest payment Net cash flow from Veblen investment

\$ \$ \$ \$ \$ \$ \$

81,600 125,000 43,400 16,400 20,000 2,604 17,396

The cash flow from the investment in Veblen will choose this strategy. This process will cause the value of stock to rise, and the value of Knight Any differences in the dollar returns to the two strategies will be eliminated, and the process will cease when the total market values of the two firms are equal.

\$ \$ \$ \$

Knight 400,000 72,000 1,632,000 1,200,000

is higher. All investors Veblen to fall. gies will be eliminated, and the he two firms are equal.

Chapter 16
Question 19 Output Area:

RE = RU + (RU - RD)(D/E)(1 - t) WACC = (E/V)RE + (D/V)RD(1 - t) = (E/V)[RU + (RU - RD)(D/E)(1 - t)] + (D/V)RD(1 - t) WACC = RU[(E/V) + (E/V)(D/E)(1 - t)] + RD(1 - t)[(D/V) - (E/V)(D/E)] WACC = RU[(E/V) + (D/V)(1 - t)] = RU[{(E+D)/V} - t(D/V)] = RU[1 - t(D/V)]

/E)(1 - t)] + (D/V)RD(1 - t)

RU[1 - t(D/V)]

Chapter 16
Question 20 Output Area:

RE = (EBIT - RDD)(1 - t)/E = [EBIT(1 - t)/E] - [RD(D/E)(1 - t)] RE = RUVU/E - [RD(D/E)(1 - t)] = RU(VL - tD)/E - [RD(D/E)(1 - t)] RE = RU(E + D - tD)/E - [RD(D/E)(1 - t)] = RU + (RU - RD)(D/E)(1 - t)

Chapter 16
Question 21 Output Area:

M&M Proposition II, with RD = RF RE = RA + (RA - RF)(D/E) CAPM: RE = βE(RM - RF) + RF ; RA = βA(RM - RF) + RF RE = βE(RM - RF) + RF = [1 + (D/E)][βA(RM - RF) + RF] - RF(D/E) βE = βA[1 + D/E]

Chapter 16
Question 22

Asset β Debt-equity ratio Debt-equity ratio Debt-equity ratio Debt-equity ratio

1.00 0.00 1.00 5.00 20.00

Output Area: βE = βA(1 + D/E) Debt-equity ratio 0.00 1.00 5.00 20.00 βE 1.00 2.00 6.00 21.00

The equity risk to the shareholder is composed of both business and financial risk. Even if the assets of the firm are not very risky, the risk to the shareholder can still be large if the financial leverage is high. These higher levels of risk will be reflected in the shareholder's required rate of return Re, which will increase with higher debt/equity ratios.