FIN 322 Tutorial 3

ABC XYZ
Equity 540,000 270,000
Debt 270,000
Total 540,000 540,000
EBIT = $61,000

a. Investment XYZ stock = $30,000

EBIT 61,000
(-) Interest payment 21600  = 270,000 x 8%
Net Income 39,400

Dividend received 4,377.78 -> = (30,000/270,000) x 39,400

Return Richard expect 14.59% -> = (4,377.78/39,400)

b. Shareholder borrow = $30,000

Interest payment = 8% x 30,000 = $2,400
Dividend received = 61,000 x (60,000/540,000) = $ 6,777.78
Return Richard = ($6,777.78 – 2,400)/30,000 = 0.1459 =14.59%

c. Since D = 0, RE = RA (ROE = ROA)

ABC Co. RE = 61,000/ 540,000 = 11.30%

XYZ Co. RE = RA + (RA - RD) (D/E) (1 – Tc)

RE = 0.1130 + (0.113 – 0.08) (270,000/270,000)
= 0.146 = 14.6%

D E
d. WACC ABC = x RD + xℜ
E+ D D+ E
= (0/640,000) x 0.08 + (540,000/540,000) x 0.113
= 11.3%

WACC XYZ = (270,000/540,000) X 0.08 + (270,000/540,000) x 0.146

FIN 322 Tutorial 3

= 11.3% When there is no taxes, the cost of capital of the fir, is unaffected by capital
structure

VL = D + E VU = Outstanding shares x Price per stock

VL = $65,000,000 + ($1,900,000 x $98) V U = $3,800,000 x $71
VL =$66,080,000 V U = $269,800,000

Yes. Since VL = $66,080,000 < VU = $269,800,000. Therefore, it is better to purchase the stock of
Levered Inc.

A. EBIT = 1,450,000 Tax rate = 21% Equity = $6,100,000 Debt = $1,600,000

Expected return on company equity = (EBIT – tax)/equity

$ 1,450,000 – ($ 1,450,000 x 0.21)
=
6,100,000
= 18.778689% = 18.78%

B.

Taco Salad Manufacturing Inc.

Assets 6,100,000 Debt  
[($1,450,000 -$304,500) /18.778689%]   Equity 6,100,000
  6,100,000   6,100,000
FIN 322 Tutorial 3

Price per share = $6,100,000/280,000 shares

= $21.79 (Before debt issue announce)
C. VL = VU + TCD
PV (Tax shield) = TcD = 0.21 x 1,600,000
= $336,000
VL = VU + TCD
= $6,100,000 + $336,000 = $6,436,000

Taco Salad Manufacturing Inc.

Old Assets 6,100,000 Debt  
PV (Tax shield) 336,000 Equity 6,436,000
  6,436,000   6,436,000

D. Price of share (after repurchase announcement) = $6,436,000/ 280,000 shares

= $22.99 per share

E. a) Shares will be repurchased (debt issue) = $1,600,000/ $22.99

= 69,595.48 shares

b) Shares of common stock (after restructuring) = (280,000 - 69,595.48)

= 210,404.52 shares

F. VL = D + E D = $1,600,000 VL = $6,436,000 E=?

E = VL – D
= $6,436,000 - $1,600,000
= $4,836,000

Taco Salad Manufacturing Inc.

Old Assets 6,100,000 Debt 1,600,000
Pv (Tax shield) 336,000 Equity 4,836,000
  $6,436,000   $6,436,000

G. Rs = R0 + (D/E) x (1- TC) x (R0 – RB)

= 0.1878 + ($1,600,000/$4,836,000) x (1-0.21) x (0.1878 – 0.06)
= 0.2212 = 22.12%
FIN 322 Tutorial 3

a. i. Steinberg
E = [0.8(2,700,000 – 900,000) + 0.2(1,100,000 – 900,000)] / (1+0.13)
E = (1,440,000 + 40,000)/ 1.13
= $1,309,734.51

D = [0.8(900,000) + 0.2(900,000)]/ 1.13

= 900,000/1.13
= $796,460.18

ii. Dietrich
E = [0.8(2,700,000-1,200,000) + 0.2(0)]/ 1.13 = $1,061,946.90
D = [0.8(1,200,000) + 0.2(1,100,000)]/ 1.13 = $1,044,247.79

b. No. I’m disagree with this statement as the risk of bankcruptcy does not affect a company’s
value. It is the actual costs of bankcruptcy that reduce the company value. This problems
assume that there are no bankcruptcy costs.
FIN 322 Tutorial 3

a. Expected value of company:

i. Low volatility project value = 0.5(3,800) + 0.5(4,000) = $3,900
ii. High volatility project value = 0.5(3,200) + 0.5(4,600) = $3,900

Both projects have same expected value of the company.

b. Expected value of company equity

i. Low volatility project value = (0.50 x 0) + [0.50*(4,000-3,800)] = $100
ii. High volatility project value = 0.5(0) + 0.5(4,600-3,800) = $400

c. Stockholders should prefer high-volatility projects because the value of equity is higher than
low volatility project.

d. The bondholders need to raise their required debt payment in order to make stockholders
indifferent between low volatility projects and high volatility project.
Expected value of equity in low volatility project = $100
100 = 0.5(0) +0.5(4,600- X)
100 = 2,300 - 0.5X
0.5X = 2300-100
X = $4,400
Amount of debt payment for bondholders will be $4,400.