Tutorial 10 Solution

Q1. According to Modigliani and Miller Propositions, does a company’s capital structure
matter?
A1. Modigliani and Miller showed that capital structure is irrelevant in a world of perfect
capital markets in which investors can borrow and lend at the same rate and managers and
investors have identical information about the company.
Q2. What are the important direct costs of insolvency and indirect insolvency costs? Which of
these are the most important for discouraging maximum debt use by corporate managers?
A2. Direct costs of insolvency are out-of-pocket cash expenses directly related to insolvency
filing and administration. Document printing and filing expenses, as well as professional fees
paid to lawyers, accountants, investment bankers, and court personnel are all examples of direct
insolvency costs. These costs can run to several million dollars per month for complex cases.
However, empirical research indicates that direct costs are much too small, relative to the pre-
insolvency market value of large companies, to truly discourage the use of debt financing.
Indirect insolvency costs, as the name implies, are economic losses that result from insolvency
but are not cash expenses spent on the process itself. These include the diversion of
management’s time while insolvency is underway, lost sales during and after insolvency,
constrained capital investment and R&D spending, and the loss of key employees after a
company becomes insolvent. Even though indirect insolvency costs are inherently difficult to
measure, empirical research clearly suggests they are significant – significant enough in many
cases to reduce the incentive for corporate managers to employ financial leverage.
Q3. Short Notes: Recapitalisation, Business risk, Financial risk, Modigliani and Miller
proposition, Pecking-order theory, Financial Leverage, Agency costs,
Problems:

P1. James International has EBIT of $35 million, debt with a market value of $30 million and
a required return on assets of 13%. Assuming a corporate tax rate of 40%, what is company’s
value?
ANS: 35/0.13 + 30(0.4) = 281 230 769
P2. Carmen Corporation finances its operations with $80 million in share and $30 million in
bonds. If the company issues $20 million in additional bonds and uses the proceeds to retire
$20 million worth of equity, what will be the company’s new debt-to-equity ratio? (Assume
zero taxes and perfect capital markets.)
ANS: Debt total = 30 + 20 = 50
Equity = 80 – 20 = 60
D/E = 0.83
P3. James International has EBIT of $875 000 for the current year. The company has $350 000
of debt outstanding with a coupon rate of 7%. Investors require a return of 15% on the
company, and the company has a corporate tax rate of 40%. What is the present value of the
company’s tax shields?

ANS: PV of tax shield = 350 000 × 0.40 = 140 000

P4. Auckland Company has net operating income of $10 million. The company has
$80 million of debt outstanding with a required rate of return of 7%; the required rate of
return for the industry is 11%. The corporate tax rate is 40%. What is the value of the
Auckland Company?
ANS:
PV of tax shield = 80 × 0.40 = 32 million
Value of unlevered company = NI/r = 10 million × (1 – 0.40)/0.11 = 6/0.11 = 54.55 million
Value of levered company = 54.55 + 32 = 86.55 million

P5. James International finances its operations with $40 million in shares with a required return
of 12% and $10 million in bonds with a required return of 6%. Suppose the company issues
$15 million in additional bonds at 8% and uses the proceeds to retire $15 million worth of
equity. If the WACC remains the same, what will be the company’s new cost of equity?
(Assume zero taxes and perfect capital markets.)
ANS:
Old WACC:
rs = r + (r – rd) × D/E
0.12 = r + (r – 0.06) × 10/40
0.12 = r + 0.25 r – 0.015
r = (0.12 + 0.15)/1.25 = 0.1080
New rs:
rd = 10/25 × 0.06 + 15/25 × 0.08 = 0.072
rs = r + (r – rd) × D/E
rs = 0.1080 + (0.1080 – 0.072) × 25/25 = 0.1080 + 0.036 = 0.144 (new cost of equity)

P6. An all-equity company has 80 000 shares outstanding worth $20 each. The company is
considering a project requiring an investment of $500 000 and has an NPV of $30 000. The
company is also considering financing this project with a new issue of equity. To ensure that
existing shareholders are indifferent to whether the company takes on this project with the
equity financing, at what price does the company need to issue the new shares?
ANS:
Old company value = 20 × 80 000 = 1 600 000
New value of the company = Old company value + New assets + NPV of project
New value of the company = 1 600 000 + 500 000 + 30 000 = 2 130 000
2 130 000 = 1 600 000 + $20 × x
x = 26 500 shares
No of new shares issued = $500 000 needed/26 500 shares = $18.87
P7. NBC Corporation has a capital structure that consists of $20 million in debt and $40 million
in equity. The debt has a coupon rate of 10%, while the industry return on equity is 15%. NBC
Corporation is unsure of the state of the economy in the next year. The tax rate facing the
company is 40%.

State of the economy Bad Good Great

EBIT $2 000 000 $5 000 000 $10 000 000
Probability 0.40 0.40 0.20
a. Given the information in the table, what are the expected earnings per share if the
company has 1 million shares outstanding?
b. The company is considering the issue of $10 million in new debt at a rate of 10%. The
funds from the new debt will be used to retire $10 million in equity. Currently, there
are 1 million shares outstanding that trade at $40 per share. Assuming the share price
will remain the same. If the company goes through with the recapitalisation, what are
the expected earnings per share in the next year?
ANS:
a. Interest payment = 20 × 0.10 = 2 million
NIBad = (2 – 2) × (1 – 0.4) = 0
NIGood = (5 – 2) × (1 – 0.4) = 1.8 million
NIGreat = (10 – 2) × (1 – 0.4) = 4.8 million
Expected EPS = (0 × 0.4 + 1.8 × 0.4 + 4.8 × 0.2)/1 = 1.68
b. Recapitalise:
Total debt = 20 mil + 10 mil = 30 mil
Number of shares = 30 million/40 per share = 750 000
Interest payment = 30 × 0.10 = 3 million
NIBad = (3 – 3) × (1 – 0.4) = 0
NIGood = (5 – 3) × (1 – 0.4) = 1.2 million
NIGreat = (10 – 3) × (1 – 0.4) = 4.2 million
Expected EPS = (0 × 0.4 + 1.2 × 0.4 + 4.2 × 0.2)/0.75 = 1.76