Capital structure – MM world (pure + taxes)

1. Assume a perfectly competitive market with no corporate or personal taxes.

Companies A and B each earn gross profits of P and differ only in their capital
structure – A is wholly equity-financed and В has debt outstanding on which it pays a
certain $100 of interest each year. Investor X purchases 10 % of the equity of A:
a. What profits does X obtain?
b. What alternative strategy would provide the same result?
c. Suppose investor Y purchases 10% of the equity of B. What profits does Y
obtain?
d. What alternative strategy would provide the same result?

2. The firm F is considering a change in its capital structure. Prior to change, the firm’s
stock sells for $100 per share. The firm has 1,000 shares outstanding. It is financed
with riskless zero coupon debt maturing in one year and having the current market
value of $10,000. The investor owns 100 shares. The firm plans to repurchase 500
shares of its outstanding stock for $50,000 and will finance the equity repurchase by
issuing $50,000 in risk free debt. Assume perfect capital market. There are no
transaction costs.
a. Demonstrate how he can undo the change in leverage to achieve cash flows
he can receive if original capital structure is not changed.
b. Comment: without transaction cost shareholder is indifferent to the changes
in firm’s capital structure.

3. A firm that has no debt has a market value of $100 million and a cost of equity of
11%. In the Miller-Modigliani world
a. What happens to the value of the firm as the leverage is changed? (Assume
no taxes)
b. What happens to the cost of capital as the leverage is changed? (Assume no
taxes)

4. What is the expected return on assets for a firm that is 60% debt-financed and pays an
expected return on debt of 9% and has a required return on equity of 20%? Assume a
firm operates in perfect capital markets with no corporate or personal income taxes.

5. Your firm’s expected operating income is $5000 and the market value of its
outstanding equity is $25000 when it is all equity financed. Assuming that the firm
operates in perfect capital markets with no corporate or personal income taxes,
calculate the required return on equity when the firm sells enough debt to repurchase
half of the outstanding equity with the rate of return on debt of 8 percent.
6. The company D is currently unlevered firm. It is considering a capital restructuring to
allow 200 of debt. The company expects to generate 151.52 in cash flows before interest
and tax in perpetuity. The corporate tax rate is 34%. its cost of debt is 10%. Unlevered
firms in the same industry have a cost of equity capital of 20%.
Required:
• What will be the new value of company D?
• What will happen to the cost of equity in case of restructuring?
• Write down the market value balance sheets of the company D assuming efficient
and perfect capital market for 3 cases: 1) before debt issue 2) just immediate upon
the announcement of coming debt issue and 3) immediate after the exchange of debt
for equity.

7. MVP Inc., a manufacturing firm with no debt outstanding and a market value of $100
million is considering borrowing $ 40 million and buying back stock. Assuming that the
interest rate on the debt is 9% and that the firm faces a tax rate of 35%, answer the
following questions:
• Estimate the annual interest tax savings each year from the debt.
• Estimate the present value of interest tax savings, assuming that the debt change is
permanent.
• Estimate the present value of interest tax savings, assuming that the debt will be
taken on for 10 years only.

8. XYZ Corporation currently has 129,58 mln. shares outstanding with a price of $28,4
per share. XYZ has perpetual risk-free debt of $2 billion dollars trading at par value
and coupon yield of 10%. Corporate tax rate is 34%. One of XYZ shareholders who
has a controlling interest has independently decided to become a CEO and run the
Corporation. He hates debt and so he announces the following recapitalization: he
will issue shares in order to pay back the debt. After the recapitalization, XYZ will be
an all-equity Corporation.
Required:
a. How much of the current market value of XYZ Corporation is due to the
debt tax shield?
b. What is the XYZ’s share price after the recapitalization? How many new
shares will be issued?
c. What are the gains and losses for existing shareholders, new shareholders,
debtholders and government as a result of XYZ recapitalization?