Corporate Finance

Questions and Practice problems_Chapter 16

Chapter 16:
Concept questions (page 519 textbook): 3, 4
Questions and Problems (page 520 textbook): 4, 5, 10, 11, 13, 14, 15

Answers:
Concept questions:
3. False. Modigliani-Miller Proposition II (No Taxes) states that the required return on a firm’s
equity is positively related to the firm’s debt-equity ratio [RS = R0 + (B/S)(R0 – 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.
4. Interest payments are tax deductible, whereas payments to shareholders (dividends) are not tax
deductible.
Questions and Problems:
4.
a. Under Plan I, EPS = $2.83.
Under Plan II, EPS = $2.54.
Plan I has the higher EPS when EBIT is $750,000.
b. Under Plan I, EPS = $5.66.
Under Plan II, EPS = $6.59.
Plan II has the higher EPS when EBIT is $1,500,000.
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
$927,500.
5.
Share price = $35.00 per share.
The value of the company under the all-equity plan is $9,275,000.
The value of the company under the levered plan is $9,275,000
10. EBIT = $3,330,000
11. 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.
13.
a. For an all-equity financed company: WACC = R0 = RS = .11 or 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 = .1165 or 11.65%
c. Using M&M Proposition II with taxes again, we get RS = .1295, or 12.95%
d. The WACC with 25 percent debt is: WACC = .1004 or 10.04%.
And the WACC with 50 percent debt is: WACC = .0908 or 9.08%
14.
a. The value of the levered firm is: VL = $798,812.50
b. The value of the unlevered firm is: VU = $751,562.50
15.
First,we need to find the market value of equity, which is:S=$663,812.50
Now we can find the cost of equity using M&M Proposition II with taxes. The cost of equity is:
RS = .1693 or 16.93%
Using this cost of equity, the WACC for the firm after recapitalization is: WACC = .1505 or
15.05%
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 II with taxes.