Corporate Finance

Questions and Practice problems_Chapter 16

Chapter 16:
Concept questions (page 519 textbook): 3, 4
Q3: Required rate on a firm's equity is positively related to the firm's debt-to-equity ratio [Rs =
Ro + (B/S)(Ro -Rb)]. Therefore, any increase in the amount of debt in a firm's capital structure
will increase the required return on the firm's equity
Q4: Interest payments are tax deductible, where payments to shareholders (dividends)
are not tax deductible
Questions and Problems (page 520 textbook): 4, 5, 10, 11, 13, 14, 15
Q4:
Under Plan I, the unlevered company, net income is the same as EBIT with no
corporate tax. The EPS under this capitalization will be
EPS = $750,000 / 265,000 shares = $2.83
Under Plan II, the levered company, EBIT will be reduced by the interest payment. The
interest payment is the amount of debt times the interest rate, so
NI = $750,000 – .10($2,800,000) = $470,000
And the EPS will be: EPS = $470,000 / 185,000 shares= $2.54
b, Under Plan I, the net income is $1,500,000 and the EPS is EPS = $1,500,000 /
265,000 shares = $5.66
Under Plan II, the net income is: NI = $1,500,000 – .10($2,800,000) = $1,220,000
And the EPS is: EPS = $1,220,000 / 185,000 shares = $6.59
c, to find the breakeven EBIT for two different capital structures, we simply set the
equations for EPS equal to each other and solve for EBIT. The breakeven EBIT is
EBIT / 265,000 = [EBIT – .10($2,800,000)] / 185,000
 EBIT = $927,500
 EBIT > break-even EBIT (plan II- LEVERED FIRM has a higher EPS)
 EBIT < break-even EBIT (plan I- UNLEVERED FIRM has a higher EPS)

Q5:
We can find the price per share by dividing the amount of debt used to repurchase
shares by the number of shares repurchased. Doing so, we find the share price is: 
Share price = $2,800,000 / (265,000 – 185,000) = $35.00 per share 
The value of the company under the unlevered plan is: 
V= $35(265,000 shares) = $9,275,000  
And the value of the company under the levered plan is: 
V= $35(185,000 shares) + $2,800,000 debt = $9,275,000

Q10:
V = $37,000,000 = EBIT/0.09
 EBIT = $3,330,000

Q11:
If there are corporate taxes, the value of an unlevered firm is:
V = EBIT(1 - T)/R0

Using this relationship, we can find EBIT as:

$37,000,000 = EBIT(1 - .35)/.09
EBIT = $5,123,076.92

The WACC remains at 9 percent. Due to taxes, EBIT for an all-equity firm would have to
be higher for the firm to still be worth $37 million

Q13:
a. For an all-equity financed company:
WACC = 11%
b. To find the cost of equity for the company with leverage we need to
use M&M Proposition II with taxes, so:
RS = R0 + (B/S)×(1-TC)×(R0 - RB) = 0.11 + (0.25/0.75)(.65)(0.11-0.08)
=> RS = 11.65%
c. RS = R0 + (B/S)×(1-TC)×(R0 - RB) = 0.11 + (0.5/0.5)(.65)(0.11-0.08)
=> RS = 12.95%
d. The WACC with 25 percent debt is:
WACC = (S/V)RS + (B/V)RB(1 - T)
WACC = 0.75(0.11) + 0.25(0.08)(1 - 0.35)
WACC = 9.55%
And the WACC with 50 percent debt is:
WACC = (S/V)RS + (B/V)RB(1 - T)
WACC = 0.5(0.11) + 0.5(0.08)(1 - 0.35)
WACC = 8.1%

Q14:
VU=$185,000(1-0.35)/0.16=$751,562.5
VL = $751,562.5 + 0.35($135,000) = $798,812.5

Q15:
135,000
RE¿ 0.16+ 663,812.5 × ( 1−0.35 ) × ( 0.16−0.09 ) =0.1693=16.93 %
135,000 663,812.5
WACC¿ 798,812.5 ×0.09 × ( 1−0.35 ) + 798,812.5 ×0.1693=0.1506=15.06 %