Pendergast, Inc., has no debt outstanding and a total market value of $180,000.

Earnings
before interest and taxes, EBIT, are projected to be $23,000 if economic conditions are
normal. If there is strong expansion in the economy, then EBIT will be 20 percent higher. If
there is a recession, then EBIT will be 30 percent lower. Pendergast is considering a $75,000
debt issue with a 7 percent interest rate. The proceeds will be used to repurchase shares of
stock. There are currently 6,000 shares outstanding. Ignore taxes for this problem.

Calculate earnings per share (EPS) under each of the three economic scenarios before any
debt is issued. Also calculate the percentage changes in EPS when the economy expands or
enters a recession.

Repeat part (a) assuming that the company goes through with recapitalization. What do you
observe?

a)

b)
M&M: case 1

market value of company $ 180,000.00

EBIT $ 23,000.00
expansion EBIT 20%

recession EBIT 30%

debt $ 75,000.00
interest rate 7%
shares outstanding 6000

NO DEBT recession current expansion

EBIT $ 16,100.00 $ 23,000.00 $ 27,600.00
interest 0 0 0
EBT $ 16,100.00 $ 23,000.00 $ 27,600.00
tax 0 0 0
net income $ 16,100.00 $ 23,000.00 $ 27,600.00
EPS $ 2.68 $ 3.83 $ 4.60
change in EPS -30.00% 20.00%

WITH DEBT recession current expansion

EBIT $ 16,100.00 $ 23,000.00 $ 27,600.00

interest $ 5,250.00 $ 5,250.00 $ 5,250.00

EBT $ 10,850.00 $ 17,750.00 $ 22,350.00

tax 0 0 0
net income $ 10,850.00 $ 17,750.00 $ 22,350.00
EPS $ 3.10 $ 5.07 $ 6.39
change in EPS -38.87% 25.92%
price per share $ 30.00
number of shares sold
for debt 2500
outstanding no of shares
after debt 3500
Repeat parts (a) and (b) in Problem 1 assuming the company has a tax rate of 35
percent.
market value of company $ 180,000.00
EBIT $ 23,000.00
expansion EBIT 20%
recession EBIT 30%
debt $ 75,000.00
interest rate 7%
shares outstanding 6000
tax rate 35%

NO DEBT recession current expansion

EBIT $ 16,100.00 $ 23,000.00 $ 27,600.00
interest 0 0 0
EBT $ 16,100.00 $ 23,000.00 $ 27,600.00
tax $ 5,635.00 $ 8,050.00 $ 9,660.00
net income $ 10,465.00 $ 14,950.00 $ 17,940.00
EPS $ 1.74 $ 2.49 $ 2.99
change in EPS -30.00% 20.00%

WITH DEBT recession current expansion

EBIT $ 16,100.00 $ 23,000.00 $ 27,600.00

interest $ 5,250.00 $ 5,250.00 $ 5,250.00

EBT $ 10,850.00 $ 17,750.00 $ 22,350.00
tax $ 3,797.50 $ 6,212.50 $ 7,822.50
net income $ 7,052.50 $ 11,537.50 $ 14,527.50
EPS $ 2.02 $ 3.30 $ 4.15
change in EPS -38.87% 25.92%
price per share $ 30.00
number of shares
sold for debt 2500
outstanding no of
shares after debt 3500
Suppose the company in Problem 1 has a market-to- book ratio of 1.0.

Calculate return on equity (ROE) under each of the three economic

scenarios before any debt is issued. Also calculate the percentage changes in
ROE for economic expansion and recession, assuming no taxes.

Repeat part (a) assuming the firm goes through with the proposed
recapitalization.

Repeat parts (a) and (b) of this problem assuming the firm has a tax rate of
35 percent. no debt no taxes
ROE
% change in ROE

with debt no taxes

ROE
% change in ROE

no debt with taxes

ROE
% change in ROE

with debt with taxes

ROE
% change in ROE
market value of equity
when no debt $ 180,000.00

MV of equity when debt $ 105,000.00

recession current expansion

8.94% 12.78% 15.33%

-30.0% 20.0%

10.33% 16.90% 21.29%

-38.87% 25.92%

5.81% 8.31% 9.97%

-30.0% 20.0%

6.72% 10.99% 13.84%

-38.87% 25.92%
Rise Against Corporation 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 210,000 shares of stock outstanding. Under Plan II,
there would be 150,000 shares of stock outstanding and $2.28 million in debt
outstanding. The interest rate on the debt is 8 percent, and there are no
taxes.

a. If EBIT is $500,000, which plan will result in the higher EPS? b. If EBIT
is $750,000, which plan will result in the higher EPS? c. What is the break-
even EBIT?

a)

b)

c)
PLAN I PLAN II

Plan I Shares 210000 plan II shares 150000

debt 2,280,000.00

int rate 8%

EBIT 500,000.00

Plan I PLAN II

EPS 2.38 EBIT 500,000.00

interest 182,400.00
EBT 317,600.00
EPS 2.12

EBIT 750,000.00

Plan I PLAN II

EPS 3.57 EBIT 750,000.00

interest 182,400.00
EBT 567,600.00
EPS 3.78

x/210000=(x-182400)/150000

150000x=210000x-210000*182400

38304000000 60000

638,400.00 is the breakeven EBIT

 PLAN I PLAN II

price per share 38.00 38.00

value of company 7,980,000.00 7,980,000.00
In Problem 4, use M&M Proposition I to find the price per share of equity
under each of the two proposed plans. What is the value of the firm? refer column K, L, M in sheet 4
er column K, L, M in sheet 4
Destin Corp. is comparing two different capital structures. Plan I would
result in 10,000 shares of stock and $90,000 in debt. Plan II would result in
7,600 shares of stock and $198,000 in debt. The interest rate on the debt is 10
percent. a)

Ignoring taxes, compare both of these plans to an all-equity plan assuming

that EBIT will be $48,000. The all-equity plan would result in 12,000 shares
of stock outstanding. Which of the three plans has the highest EPS? The
lowest?

In part (a), what are the break-even levels of EBIT for each plan as
compared to that for an all-equity plan? Is one higher than the other? Why?

Ignoring taxes, when will EPS be identical for Plans I and II?

Repeat parts (a), (b), and (c) assuming that the corporate tax rate is 40
percent. Are the break-even levels of EBIT different from before? Why or
why not?

b)

c)
d)
 PLAN I PLAN II all equity
shares 10000 7600 12000

debt 90000 198000

int rate 10% 10%

price per share 45 45 45

value of company 540000 540000 540000

EBIT 48000 48000 48000

interest 9000 19800 0
EBT 39000 28200 48000
tax 0 0 0
net income 39000 28200 48000

EPS 3.9 3.71052631578947 4

lowest highest

for break even EBIT (x)

(x-9000)/10000=x/12000 (x-19800)/7600=x/12000
12000x-12000*9000=10000x 12000x-12000*19800=7600x
2000x=12000*9000 4400x=12000*19800
x 54000 54000
breakeven EBIT for both plan I and II are same

(x-9000)/10000=(x-19800)/7600
7600x-7600*9000=10000x-19800*10000
129600000 =2400x
at EBIT= 54000
EBIT 48000 48000 48000
interest 9000 19800 0
EBT 39000 28200 48000
tax 15600 11280 19200
net income 23400 16920 28800

EPS 2.34 2.22631578947368 2.4

for break even EBIT (x) (x-9000-(x-9000)*0.4)/10000=(x-19800-(x-19800)*0.4)/7600

(0.6x-5400)/10000=(0.6x-11880)/7600

4560x-7600*5400=6000x-11880*10000

54000
same as before
rough calculations
11880
4560
77760000
Ignoring taxes in Problem 6, what is the price per share of equity under Plan
I? Plan II? What principle is illustrated by your answers? refer rows 10,11 in prev sheet

The value of the firm

er rows 10,11 in prev sheet

he value of the firm is NOT affected by changes in the capital structure

al structure
Mudpack, Inc., a prominent consumer products firm, is debating whether to
convert its all-equity capital structure to one that is 30 percent debt.
Currently, there are 7,000 shares outstanding, and the price per share is $55.
EBIT is expected to remain at $27,000 per year forever. The interest rate on
new debt is 8 percent, and there are no taxes.

Allison, a shareholder of the firm, owns 100 shares of stock. What is her cash
flow under the current capital structure, assuming the firm has a dividend
payout rate of 100 percent?

What will Allison’s cash flow be under the proposed capital structure of the
firm? Assume she keeps all 100 of her shares.

Suppose the company does convert, but Allison prefers the current all-equity
capital structure. Show how she could unlever her shares of stock to re-
create the original capital structure.

Using your answer to part (c), explain why the company’s choice of capital
structure is irrelevant.

a)
b)

c)
current equity 100%
# of shares 7000
price per share $ 55.00
proposed equity 70%
debt 30%
int rate 8%
EBIT $ 27,000.00

cash flow under current capital

structure

EBIT $ 27,000.00
interest 0
EBT $ 27,000.00
tax 0
PAT or net income $ 27,000.00
EPS $ 3.86
cash flow for Alison $ 385.71
cash flow under proposed capital
structure

EBIT $ 27,000.00 equity value

interest $ 9,240.00 debt amount
EBT $ 17,760.00 # of shares bought for debt
tax 0 # of shares remaining
Net income $ 17,760.00
EPS $ 3.62
cash flow for alison $ 362.45

Allison will have to lend (opposite to

what the company is doing) (since company is moving from unlevered to levered)
how much? 30% of shares since the company is getting 30% debt
what rate? 8% same as the company is borrowing at

proceedings from selling 30 shares $ 1,650.00

interest income from lending
cash flow from remaining 70%
shares
total cash flow for alison
$ 132.00
$ 253.71 this will be earned from levered company
$ 385.71 which comes to be same as that in a)
this is called home made leverage
$ 385,000.00
$ 115,500.00
2100
4900
ABC Co. and XYZ Co. are identical firms in all respects except for their
capital structure. ABC is all equity financed with $650,000 in stock. XYZ
uses both stock and perpetual debt; its stock is worth $325,000 and the
interest rate on its debt is 8 percent. Both firms expect EBIT to be $68,000.
Ignore taxes.

Rico owns $48,750 worth of XYZ’s stock. What rate of return is he

expecting?

Show how Rico could generate exactly the same cash flows and rate of
return by investing in ABC and using homemade leverage.

What is the cost of equity for ABC? What is it for XYZ?

What is the WACC for ABC? For XYZ? What principle have you
illustrated?

equity
stock

net income
ROE

Rico will have to borrow (since moving from levered to unlevered)

How much? $ 48,750.00
at what rate? 8%

Re=
WACC=
 unlevered levered
ABC XYZ
100% 50%
$ 650,000.00 $ 325,000.00
EBIT $ 68,000.00
$ 68,000.00 interest $ 26,000.00
10.46% Net income $ 42,000.00
ROE 12.92%

levered to unlevered)
borrow 48750 maintain debt-equity ratio same as that of the le
currently owns 48750
total investment In ABC 97500
income from ABC 10200 10200
interest expense 3900
net income from ABC for RICO 6300
ROE 12.92% which is same as that of XYZ (levered)

10.46% Re= 12.92%

10.46% NOT affected by capital WACC= 10.46%
structure
 int rate 8%

tio same as that of the levered firm

XYZ (levered)
STP Corp. uses no debt. The weighted average cost of capital is 8 percent. If
the current market value of the equity is $18 million and there are no taxes,
what is EBIT?
WACC 8%
market value of equity 18000000

EBIT 1440000
In the previous question, suppose the corporate tax rate is 35 percent. What
is EBIT in this case? What is the WACC? Explain.

required EBIT

WACC=
Firm's EBIT needs to be more to cover the 35% of taxes
EBIT determined in prev question will be for 65%

2215384.61538462

RA = (E/V)RE + (D/V)(RD)(1-TC)
8.00%
Skillet Industries has a debt–equity ratio of 1.5. Its WACC is 9 percent, and
its cost of debt is 5.5 percent. The corporate tax rate is 35 percent. D/E=3/2
D/V=3/5
What is the company’s cost of equity capital? E/V=2/5

What is the company’s unlevered cost of equity capital? a) WACC

9%
What would the cost of equity be if the debt–equity ratio were 2? What if it
were 1.0? What if it were zero?

b) unlevered cost of equity is pre tax

check Notebook session 2

for calculations

c) 1)

2)

3)
 WACC 9%
tax rate 35%
cost of debt Rd 5.50%

1.5
0.6
0.4

equity debt Re
0.4x 2.145% 17.14%

evered cost of equity is pre tax WACC

0.225025

11.39%

D/E 2
D/V 0.6667
E/V 0.333333333

Re 19.055%

D/E 1
D/V 0.5
E/V 0.5

Re 15.225%

D/E 0
D/V 0
E/V 1

Re 11.394%