Assignment Part A – Short Case of David

David Company and Goliath Company are virtually identical firms except for the use of
leverage. David has permanent debt of $200,000 with a 14% interest rate, while Goliath has no
debt. The equity capitalization rate of Goliath (in the absence of borrowing) is 20 percent. The
corporate tax rate for both firms is 40 percent. Assume that there are no personal taxes.

Data
NOI 50,000
David Debt 200,000
Interest 14%
Goliath Debt 0
Equity rate 20%
Corporate Tax rate 40%

1. What is the present value of the debt tax-shield benefit for David?
Ans Tax shield benefits = 200,000*0.4
= 80,000

2. Calculate the income available to all suppliers of capital (both debtholders and
shareholders) for the firms.
For David
Debt Kd NOI Interest EBT TAX (40%) EAT
200,000 14% 50,000 7,000 43.000 0 43,000
For Goliath
Debt Kd NOI Interest EBT TAX (40%) EAT
0 0 50,000 0 50,000 20,000 30,000

3. Calculate the total value of each firm.

Interest amount= 50,000*14% = 7000

Tax amount = 50,000*0.4 = 20,000

EAT/(1-t%)=EBT
EAT/(1-0.40%)=50,000
0.6=50.000*EAT
EAT=50,000*0.6
EAT=30.000

NOI= I + T + EAT
 NOI=7,000+20,000+30,000
NOI=57,000

V= NOI/Ko
V=57,000/0.2
V=285,000

Assignment Part B – Short Case of Zeus-Goliath

A newly merged company, Zeus-Goliath Companies (ZG), is considering what debt level, if any,
is optimal for the new firm. The firm does not have any debt at this time and has a total market
value of $300 million (all common equity). ZG understands there will be bankruptcy and agency
costs that rise as they undertake additional debt. Investment bankers have informed them that the
interest rate will also rise and together have calculated that the present value of bankruptcy costs
and agency costs will be as follows:
Debt level Present Value
$0 $0
100,000,000 6,000,000
200,000,000 12,000,000
300,000,000 20,000,000
400,000,000 30,000,000
500,000,000 50,000,000
600,000,000 95,000,000
The firm can only issue debt in increments of $100 million and believes that the present value of
tax-shield benefits is equal to 15% of the amount of the debt raised. (For ease of analysis,
assume that debt is perpetual.)

Data
Firm value 300Mn
Increments debt 100Mn
Tax Shield Benefits 15%

1. What is the present value of the tax-shield benefits at each debt level?

2. Debt level Present Value of Tax Benefits

3. $0 $0 =(15%)= 0
4. 100,000,000 100,000,000 =(15%)=15,000,000
5. 200,000,000 200,000,000=(15%)=30,000,000
 6. 300,000,000 300,000,000=(15%)=45,000,000
7. 400,000,000 30,000,000=(15%)=60,000,000
8. 500,000,000 50,000,000=(15%)=75,000,000
9. 600,000,000 95,000,000=(15%)=90,000,000

10. What is the total firm value at each potential debt level?

Ans Debt level Present value of tax shield

$0 $300m + 0 $ 300m
100,000,000 $300m + 100Mn(15%) – 6m=309m
200,000,000 $300m + 200Mn(15%) – 12m=318m
300,000,000 $300m + 300Mn(15%) – 20m=325m
400,000,000 $300m + 400Mn(15%) – 30m=330m
500,000,000 $300m + 500Mn(15%) – 50m=325m
600,000,000 $300m + 600Mn(15%) – 95m=295m

11. What is the debt ratio for the firm at its optimal capital structure?

Debt level Present value of tax shield

$0 $300m + 0 $ 300m
100,000,000 $300m + 100Mn(15%) – 6m=309m
200,000,000 $300m + 200Mn(15%) – 12m=318m
300,000,000 $300m + 300Mn(15%) – 20m=325m
400,000,000 $300m + 400Mn(15%) – 30m=330m
500,000,000 $300m + 500Mn(15%) – 50m=325m
600,000,000 $300m + 600Mn(15%) – 95m=295m

Equity = $300 + $30

=$330
Debt to equity ratio = Debt / Equity = $400/$330
= 1.21.
 Assignment Part A – Short Case of Small Town Diners
Small town Diners has a policy of treating dividends as a passive residual. It forecasts that net
earnings after taxes in the coming year will be $500,000. The firm has earned the same $500,000
for each of the last five years and has paid between $200,000 and $350,000 out in dividends in
each of those years. The company is financed entirely with equity and its cost of equity capital is
12 percent.

Data
EAT 500,000
NOI=500,000
Dividend = 200,000 into 350,000
Ks = 12%

1. How much of the coming year's earnings should be paid out in dividends if the company
has $400,000 in projects whose expected returns exceed 12 percent?

Ans
Retain $400,000 from EAT to invest in new project.
Pay Dividend $100,000 out of earning

Company should pay $100,000 out of $500,000 EAT for dividend, and retain $ 400,000
for new project investment, company should use 1/5 ratio for dividend payment.

2. How much should be paid out if the company has investment projects of $5,000,000
whose expected return is greater than 12 percent?

Firm should undertake total earning/EAT for the investment of new project, and should not
pay any dividend for this year, because of greater market return for new project. If more
financing need firm should consider external financing for this project.
 STRATEGIC FINANCE SECTION AW & AE - ASSIGNMENTS No. 5
Assignment Part B – Short Case of Big Town Diners
Big town Diners are forecasting earnings per share over the next 5 years as follows:
Year 1 2 3 4 5
EPS $2.00 $2.20 $1.90 $2.00 $2.50
The firm has $10,000,000 shares outstanding and is planning an expansion of their eateries. This
expansion will require $15 million per year for each of the next four years.

Data
Outstanding shares 10,000,0000
Expansion Required per year 15,000,000

1. Determine the dividends per share and any external financing need if the firm maintains a
constant 20% payout ratio.

Total Earning =2.5*10,000,000

Total Earning =25,000,000

=(2.5*10m -15m –(2.5*10m*0.2)

=25m-15m-5m
Excess=5m

Dividend per share = Annual Dividend/No of shares

DPS= 500,000/1,000,000
DPS= 0.50

2. Determine the dividends per share and any external financing need if the firm maintains
its current $0.50 per share dividend.

=EPS-DPS
=2-0.05
Retain earning per share =$1.5

=$1.5*10,000,000
Retain earning=15,000,000

So, we have 15m funds available from retain earning, funds sufficient to invest in new
project.
3. Determine the dividends per share and any external financing need if the firm maintains a
passive approach to dividends.

=2*10m-15m)/10m
DPS=0.5