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CBE – Accounting and Finance

FINC341 CORPORATE FINANCE

Topic 6 – Problem sets solution

1. Ghost, Inc., has no debt outstanding and a total market value of $185,000. Earnings
before interest and taxes, EBIT, are projected to be $29,000 if economic conditions
are normal. If there is strong expansion in the economy, then EBIT will be 30 percent
higher. If there is a recession, then EBIT will be 40 percent lower. The company is
considering $65,000 debt issue with an interest rate of 7 percent. The proceeds will be
used to repurchase shares of stock. There are currently 7,400 shares outstanding. The
company has a tax rate of 21 percent.
(a) (i) Calculate the earnings per share (EPS) under each of the economic conditions.

(ii) Also calculate the percentage changes in EPS when the economy expands or
enters a recession

(b) (i) Repeat part (a) assuming that the company goes through with the
recapitalization.

(ii) What do you observe?

Answer:

a. A table outlining the income statement with taxes for the three possible states of the
economy is shown below. The EPS is the net income divided by the 7,400 shares
outstanding. The last row shows the percentage change in EPS the company will
experience in a recession or an expansion economy.

Recession Normal Expansion

EBIT $17,400 $29,000 $37,700
Interest 0 0 0
Taxes 3,654 6,090 7,917
NI $13,746 $22,910 $29,783
EPS $1.86 $3.10 $4.02
%EPS –40 ––– +30

b. If the company undergoes the proposed recapitalization, it will repurchase:

Share price = Equity/Shares outstanding

Share price = $185,000/7,400
Share price = $25

Shares repurchased = Debt issued/Share price

Shares repurchased = $65,000/$25
Shares repurchased = 2,600

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 A table outlining the income statement with taxes for the three possible states of the
economy and assuming the company undertakes the proposed capitalization is
shown below.
Recession Normal Expansion
EBIT $17,400 $29,000 $37,700
Interest 4,550 4,550 4,550
EBT 12,850 24,450 33,150
Taxes 2,699 5,135 6,962
NI $10,152 $19,316 $26,189
EPS $2.11 $4.02 $5.46
%EPS –47.44 ––– +35.58

2. Round Hammer is comparing two different capital structures: An all-equity plan (Plan
I) and a levered plan (Plan II). Under Plan I, the company would have 180,000 shares
of stock outstanding. Under Plan II, there would be 130,000 shares of stock
outstanding and $1.925 million in debt outstanding. The interest rate on debt is 8
percent, and there are no taxes.
(a) If EBIT is $400,000, which plan will result in the highest EPS?
(b) If EBIT is $600,000, which plan will result in the highest EPS?
(c) What is the break-even EPS?

Answer:

a. 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 = $400,000/180,000 shares

EPS = $2.22

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 = $400,000 – .08($1,925,000)
NI = $246,000

And the EPS will be:

EPS = $246,000/130,000 shares

EPS = $1.89

Plan I has the higher EPS when EBIT is $400,000.

b. Under Plan I, the net income is $600,000 and the EPS is:

EPS = $600,000/180,000 shares

EPS = $3.33

Under Plan II, the net income is:

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 NI = $600,000 – .08($1,925,000)
NI = $446,000

And the EPS is:

EPS = $446,000/130,000 shares

EPS = $3.43

Plan II has the higher EPS when EBIT is $600,000.

c. To find the break-even EBIT for two different capital structures, we set the
equations for EPS equal to each other and solve for EBIT. The break-even EBIT is:

EBIT/180,000 = [EBIT – .08($1,925,000)]/130,000

EBIT = $554,400

3. Blitz Industries has a debt-equity ratio of 1.25. its WACC is 8.3 percent, and its cost
of debt is 5.1 percent. The corporate tax rate is 21 percent.
(a) What is the company’s cost of equity capital?
(b) What is the company’s unlevered cost of equity?
(c) What would be the cost of equity if the debt-equity ratio were 2? What is it were
1? What if it were zero?

Answer:

a. With the information provided, we can use the equation for calculating WACC to
find the cost of equity. The equation for WACC is:

WACC = (E/V)RE + (D/V)RD(1 – TC)

The company has a debt-equity ratio of 1.25, which implies the weight of debt is
1.25/2.25, and the weight of equity is 1/2.25, so

WACC = .083 = (1/2.25)RE + (1.25/2.25)(.051)(1 – .21)

RE = .1364, or 13.64%

b. To find the unlevered cost of equity we need to use M&M Proposition II with taxes,
so:

RE = RU + (RU – RD)(D/E)(1 – TC)

.1364 = RU + (RU – .051)(1.25)(1 – .21)
RU = .0940, or 9.40%

c. To find the cost of equity under different capital structures, we can again use M&M
Proposition II with taxes. With a debt-equity ratio of 2, the cost of equity is:

RE = RU + (RU – RD)(D/E)(1 – TC)

RE = .0940 + (.0940 – .051)(2)(1 – .21)

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 RE = .1618, or 16.18%
With a debt-equity ratio of 1.0, the cost of equity is:

RE = .0940 + (.0940 – .051)(1)(1 – .21)

RE = .1279, or 12.79%

And with a debt-equity ratio of 0, the cost of equity is:

RE = .0940 + (.0940 – .051)(0)(1 – .21)

RE = RU = .0940, or 9.40%

4. Meyer & Co expects EBIT to be $97,000 every year for ever. The firm can borrow at
8 percent. The company currently has no debt, and its cost of equity is 13 percent. If
the tax rate is 24 percent,
(a) what is the value of the firm?
(b) What will the value be if the company borrows $195,000 and uses the proceeds to
repurchase shares?
(c) What is the cost of equity after recapitalization?
(d) What is the WACC. What are the implications for the firm’s capital structure
decision?

Answer

The value of the unlevered firm is:

VU = EBIT(1 – TC)/RU
VU = $97,000(1 – .24)/.13
VU = $567,076.92

b. The value of the levered firm is:

VL = VU + TCD
VL = $567,076.92 + .24($195,000)
VL = $613,876.92

c. We can find the cost of equity using M&M Proposition II with taxes. Doing so, we
find:

RE = RU + (RU – RD)(D/E)(1 – TC)

RE = .13 + (.13 – .08)($195,000/[($613,877 – 195,000)](1 – .24)
RE = .1477, or 14.77%

Using this cost of equity, the WACC for the firm after recapitalization is:

d. WACC = (E/V)RE + (D/V)RD(1 – TC)

WACC = .1477[($613,877 – 195,000)/$613,877] + .08(1 – .24)($195,000/$613,877)
WACC = .1201, or 12.01%

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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 I with
taxes.