THEORY OF CAPITAL STRUCTURE’ ® Chapter2© 59 Questions What are the common assumptions of capital structure theories? Explain net income approach (NIA). Also point out important assumptions of NIA. Explain traditional theory of capital structure with respect to valuation. ‘Compare and contrast the NOI approach with NI approach and explain in what respect these __ approaches differ from the traditional view. Discuss the position of Modigliani and Miller on the issue of optimal capital structure. "The Modigliani and Miller thesis is based on unrealistic assumptions." Do you agree? Explain. Describe the various theories of the capital structure of the firm. Which theories of capital structure are more relevant and important in the Nepalese public limited companies? Justify your answer. Problems feue ae Problem 21: Equipment Company has earnings before interest and taxes (EBIT) of Rs 10 million. MAapproach The company currently has outstanding debt of Rs 20 million at a cost of 7 percent. Ignore taxes. a. _ Using the net income approach and cost of equity is 12.5 percent; compute the total value of the firm, weighted average cost of capital and debt to equity ratio. b. Assume that the firm issues an additional Rs 10 million in debt and uses the proceeds to retire the stock; the interest rate and the cost of equity remains the same. Calculate the new total value, cost of capital and market debt to equity ratio of the firm. Problem22: Jyoti Spinning Mill has net operating income (NOI) of Rs5 million and pays a as coupon rate of 10 percent on all debt. Assume that there are no taxes and all debt is gent NOM issued at par. { a, Under net income approach, assuming a cost of equity capital of 15-percent, compute the value of the firm and cost of capital for (i) all equity capital structure (ji) debt of Rs 23 million. b. Under net operating income approach, assuming a cost of capital of 125 percent, compute the value of the firm cost of equity capital for (j) all equity capital structure and (ii) debt of Rs 23 million. Given the following information of a firm: +’ Calculate the value of the firm. Calculated the weighted average cost of capital. c. Atwhich structure, firm's value is raximum? i* CORPORATE FINANCE U Company and L Company are identical in every respect except that y , Problem 24: vey tepect except unle ile L has Rs 10 million of 5 percent bonds outstanding. Assume ae a) ail arihe MM capes are met, (2) the tax rate is 40 percent, (3)EBIT ig 2 million, (4) the equity capitalization rate for U Company is 10 percent, and (6) 4, coupon rate is equal to the risk free rate, ie, 5 percent. What value would 14, estimate for each firm? Problem 25: Company U and Company L are identical in every respect except that U ;, MM mode! unlevered while L has Rs 10 million of 5 percent bonds outstanding. Assume thy (1) all of the MM assumptions are met, 2) there are no corporate and personal tay. @) EBITis Rs 2 million, and (4) the cost of equity to Company U is 10 percent,” a. What value would MM estimate for unlevered firm? b. Whatis the k, for Company U? For Company L? c.Find the value of a levered firm? dd. Whatis the weighted average cost of capital for Company U? For Company 1? e. _Recalculated part (a) to (d) assuming 40 percent tax rate. Problem 26: Sahara Company currently has EBIT of Rs 25,000 and is all-equity financed. EBIT i expected to stay at this level indefinitely. The firm pays corporate taxes equal to 35 Trade off the on percent of taxable income. The discount rate for the firm's projects is 10 percent. roblem 27: W with Taxes 7 yy jem 28; a. Whatis the market value of the firm? b. Now assume the firm issues Rs 50,000 of debt paying interest of 6 percent per year, using the proceeds to retire equity. The debt is expected to be permanent. What will happen to the total value of the firm (debt plus equity)? Recalculate your answer to (b) under the following assumptions. The debt issue raises the possibility of bankruptcy. The firm has a 30 percent chance of going to bankruptcy after 3 years. If it does go to bankruptcy, it will incur bankruptcy costs of Rs 200,000. The discount rate is 10 percent, Should the firm issue the debt? Sunflower Oil Company has Rs1 million in earnings before interest and taxes Currently it is all equity financed. It may issue Rs 3 million in perpetual debt at 15 percent interest to repurchase stock, thereby recapitalizing the corporation. There are no personal taxes. a. If the corporate tax rate is 40 percent, what is the income to all security holders (1) if the company remains all equity financed? (2) if it is recapitalized? b. Whats the present value’of the debt tax shield? The required return on equity for the company's stock is 20 percent while i remains all equity financed. What is the value of the firm? What is the value if itis récapitalized? Janata Electrical. Company has Rs4 million in debt outstanding. The: corporat? income tax rate is 35 percent. In an extensive study of investors, Devkota and Associates, an outside consulting firm, has estimated that the marginal personal t@ rale on common stock income for investoRs overall is 25 percent, Dividends ant capital gains are both included in this income, The firm also has estimated that marginal personal tax rate on debt income is 30 Percent. a. Determine the tax advantage fo Janata Electrical Company for the use of 4" under the assumption of corporate income taxes but no personal incomne taxe® (Assume the debt is perpetual and that the tax shield will be the 5 throughout) : : ce‘oblem 29: ue of the Firm th Bankruptcy wt foblem 2.10: llue of the Firm foblem 2.11: with financtal ress carernnnenne ree nse THEORY OF CAPITAL STRUCTURE ¢ ch erze 61 Determine the tax advantage with both corporate and personal income taxes. Why does your answer to part b differ from that to part a? What would be the tax advantage if the personal tax rate on common stock income were (1) 30 percent? (2) 20 percent? (Assume that all-else stays the same.) Bhandari Wine Company is presently family owned and has no debt. The Bhandari family is considering going public by selling. some of their stock in the company. Investment bankers tell them the total market value of the company is Rs 10 million if no debt is employed. In addition to selling stock, the family wishes to consider ’ issuing debt that, for computational purposes, would be perpetual. The debt then would’ be used to purchase stock, so the size of the company would stay the same. Based on various valiation studies, the net tax advantage of debt is estimated at 22 Percent of the amount borrowed when both corporate and personal taxes are taken into account. The investment banker has estimated the following present values for bankruptcy costs associated with various levels of debt: Debt (in Millions) Present Value of Bankruptcy Costs Rst 0 Given this information, what amount of debt should the family choose? MK Company is trying to determine an appropriate capital structure. It knows that as its leverage increases, its cost of borrowing will eventually increase, as will the Tequired rate of return on its common stock. The company has made the following estimates for various leverage ratios: Required rate of return on equity estes eno Without Bankruptcy and | With Bankruptcy and Agency Costs, Agency Cost = 10% 10% &% 405 105 8 it 1125 85 115 2 9 1225 3 1335 a, Ata tax rate of 50 percent, what is the weighted average cost of capital of the company at various leverage ratios in the absence of bankruptcy and agency costs? What is the optimal capital structure? as b, With bankruptcy and agency costs, what is the optimal capital structure? Sukam Company is an unlevered firm that has constant expected operating earnings (EBIT) of Re 2 million per year. The company's tax rate is 40 percent, its cost of equity is 10 percent and its market value is Rs 12 million. Management is considering the use of debt that would cost the firm-8 percent.regardless of the amount used. The firm's analysts have estimated, as an. approximation, that the t value of any future financial distress. costs is Rs 8 million, and that the probability of distress would increase with leverage according’ to the following schedule: 262 * CORPORATE FINANCE ‘According to the MM with corporate taxes:model, what is the optimal level, debt? . b. What is the optimal capital structure when financial distress costs 2, included? satis Assume that the firm's unleveraged cost of equity is 8 percent. What is th firm's optimal capital structure including financial distress costs. Mini Case SEE EEE Read the following case situations and answer the questions that follow: Gopal Khanal, CEO of Delta Solar Technologies, is concerned about his firm’s level : debt financing. The company uses short-term debt to finance its temporary workin capital needs, but it does not use any permanent (long-term) debt. Other sol: technology companies average about 30 percent debt, and Mr. Khanal wonders w: they use so much more debt, and what its effects are on stock prices. To gain sor: insights into the matter, he poses the following questions to you, his recently hire assistant a. Economic Review recently published an article on companies’ debt policies, ar the names Modigliani and Miller (MM) were mentioned several times as leadin researchers on the theory of capital structure. Briefly, who are MM, and wh: assumptions are embedded in the MM models? b. Assume that firms U and L are in the same risk class, and that both have EBIT Rs500,000. Firm U uses no debt financing, and its cost of equity is kew = 14%. Fir L has RsI million of debt outstanding at a cost of ka = Bu. There are no xe Assume that the MM assumptions hold, and then: i Pit vals of the firm, value of the stock, cost of equity and WACC for Fir and 2 y ii, Graph (a) the relationships between capital costs and leverage as measur? Bes by B/V, and (b) the relationship between value and B, © Using Ce gata given in part b, but now assuming that Firms L and U are bv! ‘subject to a 40 percent corporate tax rate, Tepeat the analysis called for in b (1) a" =: bi (2) under the MM with-tax model. z cere low suppose investors are subject to the following ta: : Tp = 30% and Ty = 25%. Nn aes i, Whatis the gain from leverage according to the Miller model? ii. How does this gain compare to the gain in the MM model with corpo"